Businesses commonly invest in other businesses, organizations, funds or projects as means of maximizing profit and capital flow. Accountants and business managers use mathematical methods when determining the value of investments, and a company’s ability to invest. The net present value (NPV) investment appraisal and capital rationing constitutes two such methods. These two financial concepts describe different things, but overlap and impact upon one another when it comes to business investment decisions.
Net present value (NPV) helps accountants, financial experts and business managers measure the value of investments. NPV constitutes an adjusted measure of an investment’s present value accounting for cost. Present value only displays the money an investment generates. NPV considers how much an investment actually pays to investors after accounting for expenditure, thus providing an accurate view of the value of an investment. A positive NPV means an investment generates a profit, and a negative NPV means it generates a loss. Calculating NPV proves mathematically complex, despite its seemingly simple nature.
Capital rationing occurs when a business places a limit on the amount it spends on investments. Such a limit arises from the process of capital budgeting, during which a company determines available capital for investments. Two types of capital rationing exist, hard capital rationing and soft capital rationing. Hard capital rationing occurs when outside sources, such as creditors, limit investment funding. Soft capital rationing occurs when sources within the company, such as accountants managers or a board of directors, impose a limit on investment funding.
Corporate Investment Strategy
Corporate investment strategy adheres to a perfect world scenario on paper. Theoretically, companies maximize revenue by investing all available capital in investment opportunities that generate a profit, or post a positive NPV. Corporate investment strategy holds in theory that a company should invest in every investment opportunity with a positive NPV, irrespective of any other considerations. However, this theory ignores the fact that every company possesses a limited amount of capital, and therefore cannot invest in every investment with a positive NPV.
Capital Rationing and NPV
Capital rationing constitutes an imperfect condition because it prevents a business from investing in every available NPV-positive opportunity. When capital rationing occurs, companies use NPV levels to determine the best investments to make with available investment capital. Sometimes, companies create a hurdle, or minimum NPV level. A company with a hurdle invests in opportunities with an NVP higher than the hurdle. In some instances, companies voluntarily impose capital rationing as a means of only investing in the best opportunities. Such businesses create criteria for investments, including ideal NPV level, and only invest in opportunities meeting or exceeding criteria.
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