CAPITAL RATIONING

It is a process of making investment decisions on viable projects where funds are limited. Investments decisions are made given a fixed amount of capital to be invested in viable projects. If a company doesnt have sufficient funds to undertake all projects with a positive NPV, this is a capital rationing situation. Causes 1) Hard capital rationing 2) Soft capital rationing Soft capital rationing It is caused by internally generated factors of the company. It is a self imposed capital rationing by the management of the company. Management may put a maximum budget limit to be spent within a specific period. Examples/causes of soft capital rationing 1) A self imposed budgetary limit where the management puts a ceiling on the maximum amount to be spent on investments. 2) Management may decide against issuing more equity finance in order to maintain control over the companys affairs by existing shareholders. 3) Management may opt not to raise more equity so as to avoid dilution in the Earning per share. 4) Management may decide against raising additional debt due to the following reasons: a) To avoid increase in interest payment commitment b) To control the gearing or operating leverage so as to maximize the financial risk. 5) If a company is small or family owned, its managers may limit the investment funds available to maintain constant growth through retained earnings as opposed to rapid expansion. Hard capital rationing It is externally imposed by the market and is caused by the factors beyond the control of the company. It occurs where the company has exhausted all its borrowing limits and is unable to raise funds externally. Causes of hard capital rationing 1) Economic factors e.g. high interest rates and high inflation 2) Perception by investors that the company is risky. Where the company is deemed risky e.g. in an infant industry or operating in a very competitive market, the investors will not provide funds to that company. 3) High competition for funds by different companies resulting into an increase in the costs of borrowing. 4) Depressed stock exchange. The companys share market price is very low and so may find it hard to raise funds from the stock market.

Project Project Project Project

1 2 3 4

Investment outlay 600 600 200 400

NPV 300 270 80 100

Profitability index 1.5 1.45 1.4 1.25

If we had an unlimited budget, we would undertake all projects and we would improve shareholder wealth bysh.750 (sum of the NPVs). With a budget of sh.1000, our decisions will be different. We would choose project 1 and 4. Project 4 is our third best option, but due to constraints of funds, we are forced to choose it. Capital rationing has the potential to misallocate resources. Funds should be diverted to the highest NPV projects. NPV cannot be correctly used to rank projects with different sizes . For example a project may have an outlay of 10000 and an NPV of 6 while another project may have an outlay of 5 and an NPV of 4. Can you say the first project is better since it has a higher NPV? The second project has had a smaller outlay and a higher NPV as a percentage of outlay (4/5) than the first project (6/10000). We should then use another method which captures the size of the investment. Profitability index is an especially useful method because it shows the profitability of each investment per currency invested. When we have capital rationing, projects should be ranked based on Profitability index. In our above example given by the table, with capital rationing, we should undertake project 1 and 4. We had a budget of 1000 and we have spent only 800. With the remainder, we can either invest in part projects e.g. fraction of either project 2 or 3. Divisible projects These are projects that can be undertaken in parts or in proportions depending on the capital available for investment. In capital rationing situations, where funds available are not enough to the entire project, the remaining funds can be partly invested in the next viable projects. Divisible projects These are projects which cannot be undertaken in portions. They have to be undertaken as a whole. In a capital rationing situation, where funds are not available or are not sufficient to invest wholly in a project then such a project is abandoned. The remainder can be invested in marketable securities. Single period capital rationing It is a situation where the company has limited amounts of funds in one investment period only. After that period, the company can access funds from various sources, e.g. issuing shares, borrowing from banks or issuing bonds.

ILLUSTRATION: ABC Ltd.is considering investing in the following independent projects Project 1 2 3 4 PV of cash flow 230000 141250 194250 162000 Initial cost 200000 125000 175000 150000 NPV 30000 16250 19250 12000 PI 1.15 1.13 1.11 1.08

The company has set a capital limit of sh.300000. Required: Advice the management on the projects to undertake. Solution If there was no capital rationing then all the 4 projects would be accepted coz they have positive NPV. However with capital rationing, the projects have to be compared using PI index. With sh.300,000, we could have invested in three options. Invest in project 1; invest in projects 2 and 3; invest in projects 2 and 4. We will select the option that gives u s the highest weighted average profitability index. A major assumption made in analysis is that the PI index of all projects is excess of one and the unused funds PI is equal to one. Weighted average PI: For option 1: 1.15(200/300) + 1.0(100/300) = 1.1 For option 2: 1.13(125/300) + 1.11(175/300) = 1.118 For option 3: 1.13(125/300) + 1.08(150/300) + 1(25/300) = 1.094 Decision: Invest in project 2 and 3 since this results in the highest weighted average PI. Multiperiod capital rationing It occurs where the company has limited amounts of funds for a longer duration of time. The capital constraints extend beyond one investment period. If we assume that its possible to undertake fractional projects then the problem can be formulated using linear programming. If the projects are indivisible, however, then integer programming should be used.

ILLUSTRATION: Assume that XYZ ltd. is considering the following available projects. Project1 1 2 3 4 5 6 7 8 9 period 1 outlay Period 2 outlay 12000 54000 6000 6000 30000 6000 48000 36000 18000 3000 7000 600 2000 35000 6000 4000 3000 3000 NPV 14000 17000 17000 15000 40000 12000 14000 10000 12000

Assume that fractional projects can be undertaken and that funds cannot be transferred from one period to another. The company has a capital budget of sh.50000 in period 1 and sh. 20000 in period 2. Required: Find the set of projects that maximizes the NPV and satisfies the capital constraints. Solution Objective function: Max NPV= t NPV t t is proportion of project t to be undertaken in the optimal solution. Subject to t C ti B i C t is the outlay of project t in period i B i is the capital budget in period i t C ti 0 Objective function: (expressed in 000 Max NPV = 14 1 + 17 2 + 17 3 + 15 4 + 40 5 + 12 6 + 14 7 + 10 8 + 12 9 Subject to 12 1 + 54 2 + 6 3 + 6 4 + 30 5 +6 6 +48 7 +36 8 +18 9 50 Period 1 constraint

3 1 + 7 2 +6 3 +2 4 +35 5 +6 6 +4 7 +3 8 + 3 9 20 Solution: 1 =1 2 =0 3 =1 4 =1 5 =0 6 =0.97 7 =0.045 8 =0 9 =1 Max NPV = 70.27 Shadow prices: Period1= 0.136 Period 2 = 1.864

Period 2 constraint

Because it has shadow price then all the funds have been used up. Project 1,3,4 and 9 are accepted wholly while project 6 and 7 are partially accepted in the optimal solution. Cash constraints are binding in both periods since they have a shadow price greater than zero. An additional shilling provided in period 1 will incre ase the NPV by 0.136 while an additional shilling provided in period 2 will increase the NPV by 1.8641.