CMA Final - Strategic Financial Management (SFM) | Concept Class - 4 | Capital Budgeting

Hello everyone, how are you all? I am Gaurav Kabra. Welcome back to our channel. For the paper of CMA Final's SFM, the conceptual clarity that you need, this playlist is being made for that conceptual clarity. And of course, in this playlist, we try to understand every financial concept with a lot of ease and time. And after that, we also do some numericals here and there, so that if it is a numerically related concept, then we can make the concept a little better. The benefit of this playlist is that most of the time, the students who are self-studying for CMA Final can pick it up. So this playlist is amazing for you. But the rest, those who have taken our course or any other course, they can also watch this video series. But because at the CMA Final level, many concepts do not need to be studied in great detail. And you can say that most teachers do not teach them in that depth. But still, if you want to make a lot of noise in finance, and if you want to have a career in finance, then you should study these concepts with ease. And this playlist is for you. But before we start today's video, there is a small announcement that if you are in CMA Final, and you are giving the exam of group 3, and you are considering the classes of paper 14 SFM, then all the details related to the classes are in the description of this video. Go and check it out. Let's start today's concept class. So today's concept class is the 4th number video in our playlist. So it is the 4th number video. I did not feel like cutting it, but instead of the highlighter, I turned on the pen. Anyway, it is the 4th number concept, and today we are going to discuss Capital Rationing. Many children will say that this is an inter-level topic. Yes, but still, it is a blessing that despite being at the inter-level, neither the inter-level nor the final comes. Many people do not have clarity about the concept of Capital Rationing that what we have to do here. So this is a video of 10 to 15 minutes. Watch it completely. I say with guarantee that you will know every concept related to Capital Rationing. Let's start. First of all, the most important thing to understand in Capital Rationing is that Capital is a limiting factor. Sir, what are you saying? Yes, I mean, not everyone has capital that they can do whatever they want in life. Yes, unless you are Mukesh Ambani. But in action, even Mukesh Ambani does not fall in this. He wanted to get his son married and then increased the prices of Jio. He increased the prices of all the plans. So even he has limited capital. If you want to spend, then you have to earn from somewhere. This is the same thing in everyone's life. Whether you do small or big business, it never happens that you have unlimited capital. But unfortunately, while studying NPV method, it is assumed that everyone has capital. It is unlimited. Well, it is not. Let me explain to you what happens when capital is unlimited. If you have unlimited capital, then NPV method says that if the projects are not mutually exclusive, it means there is no competing, you can take all the projects. So pick up every project on which you are getting NPV positive. It's simple. See NPV positive. Pick it up. Don't see how much money is being spent in it. Don't see anything. Because everyone has unlimited capital. This is the conclusion of NPV method. But the realistic thing is that NPV method is definitely a very good method. But this is a very unrealistic assumption that capital will be unlimited. In most cases, in 100% of the cases, your capital is not unlimited. Capital is limited. And that is why capital acts as a limiting factor in your decision making. In such a case, NPV method says that whatever project is visible with positive NPV, pick it up. It is not necessary to pick it up. Sometimes you have to take a choice. You have to make a choice that which project is looking good, which one is not looking good. And accordingly, you will have to take a decision. And for this decision making, you have to learn a whole new concept that is Capital Raising. I have given its introduction here. There is a general conclusion of NPV method that all projects that come with positive NPV, correct, and which is not mutually exclusive, that is, there is no competition between them, you can pick up all of them. Provided capital is unlimited. In real life, capital is not unlimited. It is written here, Capital is always a limiting factor. And hence, we will have to go beyond NPV and we will have to study a special case which is known as Capital Raising. So why do we have to learn about Capital Raising? Now you understand a little better. I will relate it again for the last time that NPV method says that everyone has money. So pick up all the projects. There are two conditions. No. 1, the project should have positive NPV. No. 2, it should not be mutually exclusive. But this assumption of NPV method that capital is unlimited is unrealistic. In real life, capital is limited. It is a limiting factor. That is why you have to study a topic like Capital Raising. This is very simple. Now let's talk about NPV versus PI. Because now PI will come back in your life. We have discussed this in a concept video that what is the difference between NPV and PI. NPV method is an absolute profitability indicator or measure which tells you exactly how much money or dollars will increase the shareholder's wealth. So the job of NPV is to tell you how much money will increase your wealth. But if we talk about PI method then PI method is not an absolute profitability measure. It is a relative profitability measure. Relative profitability measure means that it checks how much NPV has increased but it also checks how much money we have to invest to generate this NPV. So this is a little different. We are looking at profitability but in relation to the capital invested. That is why we call it relative profitability measure. So this is the biggest difference between PI and NPV. I have written here that PI method is a relative profitability measure and hence in a situation like capital rationing, it is better than NPV method. We have already discussed about NPV that NPV assumption is not right and NPV method is not right for us. It is also an absolute profitability measure. We don't need all that. We need relative measure and hence we don't use NPV in capital rationing problems. Rather we use PI method. And what do we do with PI method? We use it to rank all the acceptable projects. We rank our projects. There is nothing to do with ranking. You have to see the PI figure. Whose PI is more, his rank is better. PI is more, rank is better. And whichever project's PI is less than 1, you don't have to rank that project anyway. So you don't have to rank it a lot. It is a simple rule. You calculate PI After calculating PI, whose PI is more, his rank is higher. Whose PI is positive, you have to rank them all. Not only positive, whose PI is more than 1, you have to rank them all. Whose PI is less than 1, it means his NPV is also less than 0. And because of this, you can't accept it. So you don't have to rank it. Don't worry. I have an exercise to do this. So let's learn how to rank projects. So this is a simple situation where we have some projects. Which are A, B, C, D and E. We have initial investment, NPV and PI. For those who are still thinking what is PI's formula, let me tell you. PI's formula is 1 plus NPV by initial investment. So here is initial investment. Here is NPV. So NPV divided by initial investment is 1. So here I have already calculated PI for you. So you can see PI has different values. From this, our C number project has PI value less than 1. So there won't be any ranking allotted. As you can see, there won't be any rank given to this project. Because this project is not acceptable. This is the rule of PI method. If your PI is less than 1 in a project, you can't accept it. So clearly, hit project C. Talk about project D and E. If we rank them, the highest PI is of project A. So we will give it rank number 1. Then there is project D, which is rank number 2. It has PI of 1.3. Then with PI of 1.2, rank of B is 3rd. And 4th is project E, whose rank is 4th. So how is ranking done? I think you must have understood. It is very simple. You have to rank according to PI. While ranking, remember, higher PI will get better rank. And number 2, you have to remember, if your PI is less than 1, then there is no need to allot rank. Did you get the concept? Okay. Let's move ahead. Now the project is ranked. Now if there is a case where we have divisible projects, then how do we take decision of capital rationing? First understand what is divisible project? Divisible project is a project where you can break the project It is not necessary that there is a project where you have to allot Rs. 1 lakh. You have only Rs. 50,000. So it is not necessary to allot the whole project. You can allot only 50% portion of that project. This will give you 50% of NPV. So if there is a project of Rs. 1 lakh, where NPV is going to be of Rs. 40,000. You have only Rs. 50,000. So if you allot 50% of that project, then you will get 50% of NPV of Rs. 40,000. You will also get 50% of NPV of Rs. 50,000. So you will get NPV of Rs. 20,000 against an investment of Rs. 50,000. Practically speaking, it is not possible to do this kind of work. But still, we can theoretically assume that projects can be of divisible nature. So whenever there are divisible projects, then how to solve them? Let's discuss. I have written that in case of divisible projects, you have to follow ranks. You just have to follow rank and you have to do it before the number 1 rank, then 2nd rank, 3rd rank, 4th rank and so on. Till the time you have money, you just have to follow ranks. If you don't have enough money to invest in the next project, then you can also do it partially. Let's take an example of this. You can see that there are 5 projects here. Initial investment is also given. NPV is also given, PI is also given and I have also done the ranking. The special thing about this whole example is that there is not a single project whose PI is less than 1. This means that we have to allot rank to all of them. While allotting rank, we saw that there are actually 2 projects So I have allotted rank 2 to both project B and D. And rank 3 to the project after that and rank 4 to the last project. Even though there are 5 projects, rank 4 is an issue because it is tied to rank 1. Is it clear? So this is a very simple example where we have PI and after PI we have done the ranking. Now when there are divisible projects, you just have to follow ranks. If we go by calculations, we should first do project A, then project B, then project D. And if you still have money, then you can go to project C. And if you still have money, then you can go to project E. So we know the progression and how to follow it. Let's divide 10 lakhs. So when we divide 10 lakhs, we will first do project A. It was rank 1. It will cost 3 lakhs. We will do 100% investment and we will enjoy the 66,000 NPV. Then we will do project B. Project B requires 3.5 lakhs. Because we have so much money, we had 10 lakhs. We have invested 3 lakhs. So we still have 7 lakhs. We will invest 3.5 lakhs. So we have invested 3.5 lakhs. We are completing this project. So we will enjoy the NPV. Then comes project D. Till project D, we have spent 6.5 lakhs. 6.5 lakhs in 10 lakhs. 6.5 is spent. So we are left with 3.5 lakhs. The special thing about project D is that it requires only 2 lakhs. Because we have 2 lakhs. We can complete it. Then we will do it 100% as well. We will enjoy the NPV. But when we come to project C, this project originally costs 4.5 lakhs. But we do not have 4.5 lakhs. We have spent 8.5 lakhs. We are only left with 1.5 lakhs. So in this way, instead of 4.5 lakhs, which is the initial cost, you are investing 1.5 lakhs. So you are able to take up only 1 third of the project. So 33.33% is the total investment that you have done. Accordingly, the NPV is also 1 third. So 81,000 was given. 1 third of 81,000 is 27,000 rupees. And that is the NPV that you will derive from project C. As far as project E is concerned, its rank is 4. But there is not a single rupee to invest in it. So we will not invest anything here. In this whole process, you will get the best return here. Because in divisible, the most efficient decisions are taken. So in division, our profit is 2.3 lakhs. Which is a very great answer. But let me tell you, this was of divisible nature. Where we follow the ranks. And if someone wants to do the project and runs out of money in between, then we finish the project there. We enjoy the proportionate share of NPV. All these are bookish talks. This will not happen in real life. But if it happens, then yes, you will generate this much profit. Is it possible to make a profit above this profit? No, it is not possible. Whatever result you got in divisible project, to get a better result than that. If you have made the question wrong, then it is a different matter. But if you have made the question right, then it is impossible to generate more NPV than this amount. Next we come to the final category. Which is indivisible projects. Now this is different. We talked about capital rationing in the class. In which I told you, if there is a lack of capital, then you cannot run on the basis of NPV rule. You have to follow PI method. Then I said, if you want to get results in PI, then PI should be more than 1 or less than 1. And apart from that, the one whose PI is more, you have to give him a better rank. Then we followed in divisible project, that the one whose rank is more, you have to give him a better rank, as long as you have money. If in any project, you don't have enough money, then also you have to give him a better rank. And complete that percentage, as long as you have money. The benefit of this is, you will be able to invest all the money. And at the same time, you will also get a proportionate NPV share as well. For example, in my previous case, I had an NPV of 81,000. But still, I was able to enjoy an NPV of 27,000, even after taking 33.33% of the project. But all this will not happen in indivisible. In indivisible ranks, or in indivisible projects, blindly following ranks can be extremely devastating. Yes, here you have to apply a lot of permutation combination. I can say, you will have to do trial and error. If you blindly follow ranks, then your results can be inefficient. For this, a very good example is given in your own institute's math. I have also replicated it. Let's discuss it. Here I will show you, if this same example, my bad, if we discuss the same example here, this same example, then you can see, we have ranks, but blindly following those ranks will not give a good result. Let me show you. If we blindly follow ranks, then we should do project A, B and D. If we do A, B, D, then our total capital will be engaged of 8.5 lakhs. Our 1.5 lakhs unutilized balance will be left. On the contrary, our NPV will also be very less. It will be 66 plus 70 plus 40. Then we have another option. No problem. Let's subtract 1, 2 and take 3. So basically, we will take up 1, 2, 3. You can take 1, 2, 3. But to do this, you need 11 lakhs. But you don't have that. So you will think, let's leave 3. We will take up E. We will take up E somehow. If you take up E, then you will have another combination. Basically, by blindly following ranks, you will not get results. Ranks can help. But rank is everything. So how will we get the answer here? We will get the answer here. So here you can see, we have made many combinations. For example, we made a combination of A, B, D. So A, B, D is rank 1 plus 2 plus 2. We took 3 good ranks and added them. So we found that investment is only 8.5 lakhs. And NPV is also 1,76,000 only. So technically speaking, NPV is not that good. Then we said, let's change something else. So we did A plus D plus C. With this, rank 1, rank 2 and rank 3 are captured. This is also fine. But only 9.5 lakhs are invested in this. And NPV has improved. Where NPV was earlier 1,76,000. Now it is 1,87,000. So it is definitely an improvement. It is a better alternative. But is it the best? No. The best is B, D and C. Which is exceptionally made from rank 2, 2 and 3. Brother, you can think rank 1 did not come in your answer. There can be no better realization for you that rank in case of indivisible project may not give you true picture. Because sometimes we get biased that rank 1 will definitely come. It is not necessary. In the last case, rank 1 is not there. It has both rank 2 projects and rank 3 project. And all of them got 10 lakhs investment. And interestingly, NPV is coming at 1,91,000. So you are able to generate a good amount of NPV and you are able to complete the investment. So somehow I can say that this is the most efficient decision even without considering ranks in a pure form. Otherwise we keep going behind rank 1. But you have to open your mind and think that it is not necessary that rank 1 will be selected every time. Sometimes other ranks can also be selected This was a very interesting feature of NPV. And this makes capital raising a little bit useful. I know you will have questions in your mind. Sir, more combinations are possible. Yes, it is possible. If you want, you can make them and check. I have checked already. There will be no better result than this. So I have given you the efficient solution. But if you want, you can play a little more. You can still make more combinations here as long as the total investment in these projects is less or equal to 10 lakh rupees. I want to clarify once again that don't compare divisible and indivisible projects. Their functionality is very different. In a divisible project, rank is everything. You go according to the rank. And in a project where the money is less, you can proportionate it. This will not happen in an indivisible project. In the case of an indivisible project, you can follow the ranks. But it is not necessary that the ranks usually give you the right results. You will have to try and you will have to fail sometimes. But you will have to make combinations and decide the NPV. You will go with the highest NPV. It is obvious that if you compare divisible and indivisible projects, the profit of the divisible project will never come in the case of an indivisible project. Because this is not such an efficient method. The divisible method is more efficient. But still, it is not divisible in the real world. It is indivisible in the real world. That is, whatever it is, you will have to find efficiency from it. So this was the complete knowledge of capital rationing for you. I have nothing else here. We have discussed this all. And if you want all this, you can practice better with your institute math and prepare this topic by asking questions. With that being said, I hope you enjoyed this video. I will see you in the next video. Till then, bye-bye, take care, enjoy yourselves. Please and please keep studying. At the same time, if you like the video, then please like it. Leave your comments. I really like them. If you write good things, it will feel good. Apart from this, you can share this playlist with friends. Especially those who are having difficulty in achieving conceptual clarity in SFM. So yes, with that being said, I will see you in the next one. Till then, bye-bye, take care, enjoy yourselves. Please and please keep studying.