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Optimal Capital Budget

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Optimal Capital Budget
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Choosing the Optimal Capital Budget  Finance theory says to accept all positive NPV projects.  Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:

Increasing Marginal Cost of Capital

Externally raised capital can have large flotation costs, which increase the cost of capital. Investors often perceive large capital budgets as being risky, which drives up the cost of capital.
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An increasing marginal cost of capital. Capital rationing
Copyright © 1999 by The Dryden Press All rights reserved.

Copyright © 1999 by The Dryden Press

All rights reserved.

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Capital Rationing If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital. Capital rationing occurs when a company chooses not to fund all positive NPV projects. The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
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Copyright © 1999 by The Dryden Press All rights reserved. Copyright © 1999 by The Dryden Press All rights reserved.

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Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital.
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Copyright © 1999 by The Dryden Press All rights reserved.

Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.
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Copyright © 1999 by The Dryden Press All rights reserved.

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Blum Industries has 5 potential projects:

We’ve seen how to evaluate projects. We need cost of capital for
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