Define Capital Rationing

Capital rationing is a business decision to limit the amount available to spend on new investments or projects. The practice describes restricting channels of outflow of funds by placing a cap on the number of new projects. Capital rationing may be employed by different kinds of companies to achieve desired financial targets. The theory behind capital rationing practices is that, when fewer new projects are undertaken, the company is better able to manage them through more time and resources dedicated to existing projects and each new project. Under capital rationing, the management has not simply to determine the profitable investment opportunities, but it has also to decide to obtain that combination of the profitable projects which yields highest net present value within the available funds.

Factors

Factors influencing capital rationing decisions include both financial situations and management philosophy. Companies may wish to limit capital spending when the NPV (net present value) or IRR (internal rate of return) has a pronounced effect on the overall budget amount, or when potential investment opportunities are unfeasible, if current commitments are extensively pursued. Other factors that influence capital rationing decisions include the amount of funds that come from current operations and the feasibility of acquiring capital, either by borrowing or issuing additional stock. In addition, rationing may be implemented in different ways by growth-minded management and management with a more conservative approach.

Artificial Constraint

Capital rationing decisions are implemented only in certain scenarios, such as when a company does not have enough funds to invest in projects that have promise. When there are more projects than funds available, only the most lucrative ones are considered, and other projects, even if they are profitable, are excluded. This is known as artificial constraint, because the amount to be spent on projects is specified by management. Capital rationing occurs due to management fears of sudden growth bursts or when management is reluctant to use external financing.

Types

Capital rationing can be classified into hard and soft, based on whether the factors are external or internal. Hard capital rationing is when constraints that may affect business

decisions are externally determined; hard capital rationing does not occur under perfect market conditions. Soft capital rationing occurs when investment expenditure is controlled and limited internally, by restrictions imposed by management.

External Reasons

There are two kinds of reasons for capital rationing--external and internal. When a business is unable to borrow funds from outside sources, it is an external reason for capital rationing. A firm may be unable to borrow funds because of internal financial shortages, substandard operating performance, unfavorable credit conditions or when it introduces a new, untested product. Banks are particularly reluctant to lend to small businesses and individuals with a less-than-satisfactory performance.

Internal Reasons

Internal reasons for capital rationing include management apprehension that expansion would lead to a dilution of control. In a privately-owned company, management may want to limit growth of business to have a stronger hold on the business. In larger companies, upper management may specify spending limits for each department, following a comprehensive corporate strategy. Internal reasons also include human resource constraints, in which the company may not have adequate middle management personnel to cover expansion. Debt constraints are also part of internal reasons for capital rationing; it might be that debt issued earlier prohibit the company from pursuing more debt, because of impositions placed by the earlier debt.

Profitability Index
Ratio of the total present value (PV) of future cash inflows to the initial investment (I). That is, PV/I. This index is primarily used as a means of ranking projects in descending order of attractiveness. In a single project case, if the index is greater than 1, the project should be accepted. For example, consider the following data:

The profitability index is 1.31 (PV / I = $16,950/$12,950). Note PV = $3,000 X PV of an annuity

of $1 for 10 years and 12% = $3,000 X 5.65 = $16,950. Since this project generates $1.31 for each dollar invested (or its index is greater than 1), it should be accepted.

How to calculate the Profitability Index? Present Value Of Future Cash Flows Profitability Index= -------------------------------------Initial Cash Investment Example: An investor purchases a real estate investment property and puts $20,000 in down payment and closing costs. The net cash flows for year 1, 2, 4 and 5 are forecasted to be $700, $900, $1,150, $1,375, $1,500 and $125,000 respectively. And the investor is planning on selling the real estate investment property on the fifth year for $125,000. Initial Investment : $75,000 Year 1 Cash Flow : $700 Year 2 Cash Flow : $900 Year 3 Cash Flow : $1,150 Year 4 Cash Flow : $1,375 Year 5 Cash Flow : $1,500 Year 5 Sale Proceeds Cash Flow : $125,000 STEP 1: Required Rate of Return Required Rate of Return (RRR) = 11.94% STEP 2: Year 1 Net Present Value $700 -----------Year 1 NPV= 1 (1 + 11.94) Year 1 NPV= $625.32 STEP 3: Year 2 Net Present Value $900 -----------Year 2 NPV= 2 (1 + 11.94)

Year 2 NPV= $718.20 STEP 4: Year 3 Net Present Value $1,150 -----------Year 3 NPV= 3 (1 + 11.94) Year 3 NPV= $819.79 STEP 3: Year 4 Net Present Value $1,375 -----------Year 4 NPV= 4 (1 + 11.94) Year 4 NPV= $875.61 STEP 5: Year 5 Net Present Value Year 5 Cash Flow= Rental + Sale Year 5 Cash Flow= $1,500 + $125,000 Year 5 Cash Flow= $126,500 $126,500 -----------Year 5 NPV= 5 (1 + 11.94) Year 5 NPV= $71,961.11 STEP 6: Add up all the Net Present Values Discounted Cash Flow = Year 1 NPV

Year 2 NPV Year 3 NPV Year 4 NPV Year 5 NPV ---------Total Discounted Cash Flow Discounted Cash Flow = $625.32 $718.20 $819.79 $875.61 $71,961.1 1 ---------$75,000

STEP 7: Substitute formula values Present Value Of Future Cash Flows Profitability Index= -------------------------------------Initial Cash Investment $75,000 = Profitability Index -------------------------------------$75,000 Profitability Index= 1.00