What are the constraints in selection of multiple projects?



Ans.  When investment projects are considered individually, any of the discounted cash flow technique may be applied for obtaining a correct accept or reject criteria. In an existing organisation, however, capital investment projects often cannot be considered individually or in isolation. This is because the pre-conditions for viewing projects individually- project independence, lack of capital rationing, and project divisibility are  rarely, if ever, fulfilled. Under the constraints obtained in the real world, the so called rational criteria per se may not necessarily signal the correct decision.
 Constraints
Project Dependence : Project A and B are economically dependent if the acceptance or rejection of one changes the cash flow stream of the other or affects the acceptance or rejection of the other. The most conspicuous kind of economic dependency occurs when projects are mutually exclusive. If two or more projects are mutually exclusive, acceptance of any one project out of the set of mutually exclusive project automatically precludes the acceptance of all other projects in the set. From an economic point of view, mutually exclusive projects are substitutes for each other. For example, the alternative possible uses of a building represent a set of mutually exclusive projects. Clearly if the building is put to one use, it cannot be put to any other use. Economic dependency also exists when projects, even though not mutually exclusive, negatively influence each other’s cash flows if they are accepted together. Bierman and Smidt have given an excellent illustration of this kind of economic dependency: a project for building a toll bridge and a project for operating a toll ferry. These two project are such that when they are undertaken together, the revenues of one will be negatively influenced by the other.
Further, the projects are said to have positive when there is complementarily between projects. If undertaking a project influences favourably the cash flows of another project, the two projects are complementary projects. Complementarily may be of two types: asymmetric complementarily and symmetric complementarily. In asymmetric complementarity, the favourable effect extends only in one direction.
Capital Rationing: Capital rationing exists when funds available for investment are inadequate to undertake all projects which are otherwise acceptable. Capital rationing may arise because of an internal limitation or an external constraint. Internal capital rationing is caused by a decision taken by the management to set a limit to its capital expenditure outlays; or, it may be caused by a choice of hurdle rate higher than the cost of capital of the firm. Internal capital rationing, in either case, results in rejection of some investment projects which otherwise are acceptable.
External capital rationing arises out of the inability of the firm to raise sufficient amounts of funds at a given cost of capital. In a perfect market, a firm can obtain all its funds requirement at a given cost of capital. In the real world, however, the firm can raise only a limited amount of funds at a given cost of capital. Beyond a certain point, the cost of capital tends to increase.

Project Indivisibility : Capital projects are considered indivisible, i.e. a capital project has to be accepted or rejected in a project cannot be accepted partially.Given the indivisibility of capital projects and the existence of capital rationing, the need arises for comparing projects. To illustrate this point, consider an example. A firm is evaluating three projects A, B, and C which involve an outlays of Rs. 0.5 million, Rs. 0.4 million, and Rs. 0.3 million respectively. The net present value of these projects are Rs. 0.2 million, Rs. 0.15 million, Rs. 0.1 million respectively. The funds available to the firm for investment are Rs. 0.7 million. In this situation, acceptance of project A (project with the highest net present value) which yields a net present value of Rs. 0.2 million results in the rejection of projects B and C which together yield a combined net present value of Rs. 0.25 million. Hence, because of the indivisibility of projects, there is a need for the comparison of projects before the acceptance/rejection decisions are taken.

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