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Exxaros managers are ambitious and wish to expand their range of activities. They have produced a report for the head office detailing five projects requiring

Exxaros managers are ambitious and wish to expand their range of activities. They have produced a report for the head office detailing five projects requiring large initial investments. After reading the report the head office say they have a policy allowing unit managers to select investment projects without interference from their office. However, they do set a limit on the amount spent in any one period. In the case of Exxaro this limit is to be R110 000 at Time 0 for these projects, which if accepted will commence immediately. The five projects are mutually exclusive (that is, taking one does not exclude the possibility of taking on another), each one can only be undertaken once and they are all divisible.

Points in time yearly

0

1

2

3

4

(R'000)

(R'000)

(R'000)

(R'000)

(R'000)

Project 1

-35

0

60

0

0

Project 2

-50

30

30

30

0

Project 3

-20

10

10

10

10

Project 4

-30

15

15

15

15

Project 5

-60

70

0

0

0

None of the projects lasts more than four years and cash flows are confined to within the four-year horizon.

Assume:

  • The cost of capital is 10 per cent
  • No inflation
  • No tax
  • All cash flows occur on anniversary dates

5.1. What is the optimal allocation of the R110 000 and the resulting net present value?

5.2. How would your answer above (5.1) change if the cost of capital is decreased by 2 per cent?

5.3. Distinguish between soft and hard capital rationing and explain why these forms of rationing occur.

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