FinancialManagement

Unit10

Unit10
Structure

CapitalRationing

10.1 10.2 10.3 10.4

Introduction MeaningofCapitalRationing StepsinvolvedinCapitalRationing Summary TerminalQuestions AnswertoSAQsandTQs

10.1 Introduction: Capital budgeting decisions involve huge outlay offunds. Funds availablefor projects may be limited. Therefore, a firm has to prioritize the projects on the basis of availability of funds and economiccompulsionofthefirm.Itisnotpossibleforacompanytotakeupalltheprojectsata time.Thereistheneedtorankthemonthebasisofstrategiccompulsionandfundsavailability. Sincecompanieswillhavetochooseonefromamongmanycompetinginvestmentproposalthe needtodevelopcriteriaforCapitalrationingcannotbeignored.Thecompaniesmayhavemany profitable and viable proposals but cannot execute because of shortage of funds. Another constraintisthatthefirmsmaynotbeabletogenerateadditionalfundsfortheexecutionofallthe projects.Whenafirmimposesconstraintsonthetotalsizeoffirmscapitalbudget,itisrequires CapitalRationing.WhenCapitalisrationedthereisaneedtodevelopamethodofselectingthe projects that could beexecuted with the companys resources yetgivethehighest possiblenet presentvalue. LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing. 1.Explainthemeaningofcapitalrationing. 2.Explaintheneedforcapitalrationing. 3.Explaintheprocessofcapitalrationing. 4.Explainthevariousapproachestocapitalrationing.

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10.2 MeaningofCapitalRationing:
Because of the limited financial resources, firms may have to make a choice from among profitableinvestmentopportunities.Capitalrationingreferstoasituationinwhichthefirmisunder aconstraintoffunds,limitingitscapacitytotakeupandexecutealltheprofitableprojects.Sucha situationmaybeduetoexternalfactorsorduetotheneedtoimposeinternalconstraints,keeping inviewoftheneedtoexercisebetterfinancialcontrol.

WhyCapitalRationing ReasonsforCapitalRationing: CapitalRationingmaybedueto a.Externalfactors b.Internalconstraintsimposedbymanagement

External Capital Rationing: External Capital Rationing is due to the imperfections of capital marketsImperfectionmaybecausedby: a. Deficienciesinmarketinformation b. RigiditiesthathampertheforceflowofCapitalbetweenfirms. Whencapitalmarketsarenotfavourabletothecompanythefirmcannottapthecapitalmarketfor executingnewprojectseventhoughtheprojectshavepositivenetpresentvalues.Thefollowing reasonsattributetotheexternalcapitalrationing: 1. Inabilityofthefirmtoprocurerequiredfundsfrom Capitalmarketbecausethefirmdoesnot commandtherequiredinvestorsconfidence. 2. Nationalandinternationaleconomicfactorsmaymakethemarkethighlyvolatileandinstable. 3. Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the marketforfunds. 4. HighCostofissueofSecuritiesI,eHighfloatationcost.Smallerfirmssmallerfirmsmayhave toincurhighcostsofissueofsecurities.Thisdiscouragessmallfirmsfromtappingthecapital marketsforfunds.

InternalCapitalRationing:Impositionsofrestrictionsbyafirmonthefundsallocatedforfresh investmentiscalledinternalcapitalrationing.Thisdecisionmaybetheresultofaconservative policy pursued byafirm. Restriction maybe imposed on divisionalheads onthe totalamount thattheycancommitonnewprojects. AnotherinternalrestrictionforCapitalbudgetingdecisionmaybeimposedbyafirmbasedonthe need to generate a minimum rate of return. Under this criterion only projects capable of
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generatingthemanagementsexpectationontherateofreturnwillbecleared.Generallyinternal capitalrationingisusedbyafirmasameansoffinancialcontrol.

SelfAssessmentQuestions1 1. When a firm imposes constraints on the total size of its capital budget, it is known as _____________. 2.Internalcapitalrationingisusedbyafirmasa______________________. 3.Rigiditiesthataffectthefreeflowofcapitalbetweenfirmscause_________________. 4.Inabilityofafirmtosatisfytheregularitynormsforissueofequitysharesfortappingthemarket forfundscauses__________________.

10.3 StepsinvolvedinCapitalRationing StepsinvolvedinCapitalRationingare: 1. Rankingofdifferentinvestmentproposals 2. Selectionofthemostprofitableinvestmentproposal

Rankingofdifferentinvestmentproposals Thevariousinvestmentproposalsshouldberankedonthebasisoftheirprofitability.Rankingis doneonthebasisofNPV,ProfitabilityindexorIRRinthedescendingorder. ProfitabilityindexasthebasisofCapitalRationing Thefollowingdetailsareavailable: CashInflows Project A B C CostofCapitalis15% ComputationofNPV Year Cashinflows PVfactorat15% PVofCashin flows 1 2 3 60,000 50,000 40,000 0.870 0.756 0.658 52,200 37,800 26,320 InitialCashoutlay 1,00,000 50,000 50,000 Year1 60,000 20,000 20,000 Year2 50,000 40,000 30,000 Year3 40,000 20,000 30,000

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PVofCashinflow InitialCashoutlay NPV

1,16,320 1,00,000 16,320

PVofCashinflows

Profitabilityindex= PVofCashoutflows
1,16,320

= 1,00,000
ProjectB

=1.1632

Year

Cashinflows

PVfactorat15%

PVofCashin flows

1 2 3

20,000 40,000 20,000

0.870 0.756 0.658 PVofCashinflow InitialCashoutlay NPV

17,400 30,240 13,160 60,800 50,000 10,800

Profitabilityindex=60,800=1.216 50,000 ProjectC Year Cashinflows PVfactorat15% PVofCashin flows 1 2 3 20,000 30,000 30,000 0.870 0.756 0.658 PVofCashinflow InitialCashoutlay NPV 17,400 22,680 19,740 59,820 50,000 9,820

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Profitabilityindex=59,820=1.1964 50,000 RankingofProjects Project Absolute A B C 16320 10800 9820 NPV Rank 1 2 3 ProfitabilityIndex Absolute 1.1632 1.216 1.1964 Rank 3 1 2

If the firm has sufficient funds and no capital rationing restriction, then all the projects can be acceptedbecauseallofthemhavepositiveNPVs. Let us assume that the firm is forced to resort to capital rationing because the total funds availableforexecutionofprojectisonlyRs.1,00,000. InthiscaseonthebasisofNPVCriterion,projectAwillbecleared.Itincursaninitialcashoutlay ofRs.1,00,000.AfterallocatingRs.1,00,000toprojectA,leftoverfundsisnil.Therefore,onthe basisofNPVcriterionotherprojectsi,eB&Ccannotbetakenupforexecutionbythefirm.Itwill increasethenetwealthofthefirmbyRs.16,320. On the other hand on the basis of profitability index, project B and C can be executed with Rs.1,00,000 because both of them incur individually an initial cash outlay of Rs.50,000. Therefore,withtheexecutionofprojectsBandC,increaseinnetwealthofthefirmwillbe10800 +9820=Rs20620 The objective is to maximize NPV per rupee of Capital and projects should be ranked on the basis of the profitability index. Funds should be allocated on the basis ranks assigned by profitabilityindex.

Evaluation: 1. PIruleofselectingprojectsunderCapitalrationingmaynotyieldsatisfactoryresultbecause of project indivisibility. When projects involving high investment is accepted many small projectswillhavetobeexcluded.ButthesumoftheNPVsofsmallprojectstobeaccepted maybehigherthantheNPVofsinglelargeproject. 2. ItalsosuffersfromthemultiperiodCapitalconstraints. Programmingapproach:TherearemanyprogrammingtechniquestoCapitalrationing.Among themare:

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1. LinearProgramming:LPapproachtoCapitalrationingtriestoachievemaximumNPVsubject tomanyconstraints.HeretheobjectivefunctionismaximisationofsumoftheNPVsofthe projects. Here the constraints matrix incorporates all the restrictions associated with Capital rationing imposedbythefirm. 2. IntegerProgramming:LPmaygiveanoptimalmixofprojectsinwhichtheremaybeneedto accept fraction of a project. Accepting fraction of a project is not feasible. Therefore, optimummaynotbeattainable.Theactualimplementationofprojectsmaybesuboptimal. Whenprojectsarenotdivisible,integerprogrammingcanbeemployedtoavoidthechancesof acceptingfractionofprojects. Theadvantageofprogrammingapproachisthatitprovidesinformationondualvariables.Italso givesinformationonshadowpricesofbudgetconstraints.Dualvariablesprovideinformationfor decisionontransferoffundsfromoneyeartoanotheryear

Thedemeritsofprogrammingapproachisthat a. Costlytousewhenlarge,indivisibleprojectsarebeingexamined. b. They are deterministic models. But variables of Capital budgeting are subject to change makingtheassumptionofdeterministichighlyinvalid.

SelfAssessmentQuestions2 1. Thetwostepsinvolvedincapitalrationingare__________and__________________. 2. Projectindivisibilitycanleadtosuboptimalresultwhen____________isusedforcapital rationing. 3. Objectivefunctionunderlinearprograminingapproachis___________. 4. Whenprojectarenotdivisible______________canbeemployedtoavoidthechangesof acceptingfractionofaproject.

10.4Summary
Oftenfirmsareforcedtorationthefundsamongtheeligibleprojectsthatthefirmwantstotake up.Theinabilityofthefirminfindingadequatefundsforexecutionoftheprojectscouldbedueto manyfactors.Itmaybeduetoexternalfactorsorinternalconstraintsimposedbythe management.Externalcapitalrationingoccursmainlybecauseofimperfectionsincapital markets.Internalcapitalrationingiscausedbyrestrictionsimposedbythemanagements.

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TerminalQuestions 1. Examinetheneedforcapitalrationing. 2. Examinethereasonsforexternalcapitalrationing. 3. InternalcapitalrationingisusesbyfirmsforexercisingfinancialcontrolHowdoesafirm achievethis? 4. Briefexplaintheprocessofcapitalrationing.

AnswertoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Capitalrationing. 2. Meansoffinancialcontrol. 3. Externalcapitalrationing. 4. Externalcapitalrationing.

SelfAssessmentQuestions2 1. Rankingtheproject,selectionofthemostprofitableinvestmentproposal 2. Profitabilityindex 3. MaximisationofsumofNPVsoftheprojects. 4. Integerprogramming

AnswerforTerminalQuestions 1. Refertounit10.1 2. Refertounit10.1 3. Refertounit10.1 4. Refertounit10.3

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