This final lesson covers the practical considerations in capital budgeting, including capital rationing, the importance of post-audits, and the integration of capital budgeting with the firm’s cost of capital and capital structure decisions.

• Capital Rationing: Capital rationing occurs when a firm has more acceptable investment opportunities than it has funds to finance them. This may be due to:

  • Soft Capital Rationing: Internal constraints imposed by management (e.g., limiting investment budget to control spending)

  • Hard Capital Rationing: External constraints where the firm cannot raise additional capital in the financial markets

• Selecting Projects under Capital Rationing: When funds are limited, firms must select the combination of projects that maximizes total NPV within the available budget. This often involves evaluating projects and ranking them by profitability index (NPV per dollar invested).

• Post-Audits: A post-audit is a review of an investment project’s actual performance compared to its projected performance. The post-audit provides valuable feedback by:

  • Identifying areas where estimates were inaccurate

  • Improving future forecasting accuracy

  • Holding managers accountable for investment decisions

  • Identifying projects that may need corrective action

• The Cost of Capital and Capital Budgeting Connection: The capital budgeting decision and the capital structure decision cannot be treated separately when corporate taxes are considered. The cost of capital is not dependent on how and where the capital was raised but on the use of funds. The Weighted Average Cost of Capital (WACC) serves as the discount rate for evaluating projects, and the relationship between capital structure and project valuation is reflected through the tax shield benefits of debt financing.

• Two Approaches to Integrating Capital Structure and Capital Budgeting:

  • Adjusted Present Value (APV) Method: Evaluate the project as if it were equity-financed, then add the value of any financing subsidies (tax shields)

  • WACC Method: Adjust the discount rate (WACC) to reflect the project’s financing mix and discount the project’s cash flows