CAPITAL RATIONING

JUNE 2014 Q 1
(a)
(b)
(c)

Define capital rationing.

(2 marks)
Distinguish between Hard and Soft capital rationing clearly indicating the causes
of each.
(14 marks)
How can a firm overcome capital rationing problem?
(4 marks)

ANSWERS
Capital rationing is a situation where the company has at its disposal viable projects i.e.
projects with positive NPV but cannot undertake all the projects due to limited
resources/capital constraints. It is the process of making investment decisions given a
fixed amount of capital to be invested in viable projects. If a company is unable to
undertake all the projects with positive NPV due to limited resources, then it is in a
capital rationing situation.
Types of capital rationing
(a)
(b)

Single period capital rationing: this is a situation where funds a limited for only one
investment period but becomes available in the subsequent years.
Multi period capital rationing: it is where the company has insufficient funds
extending beyond one investment period.

Types of investment projects

(a)
(b)

Divisible investment: these are projects that can be undertaken in proportions

where capital is limited.
Indivisible projects: projects that cannot be undertaken in proportions. If capital is
not enough, the project will be abandoned all together.

Causes of capital rationing

1. Soft capital rationing:
It is caused by self-imposed factors or internal factors that are unique in a particular
company hence can be controlled by the management. Examples are;
(a)

Where the management has placed a ceiling on the amount of funds available for
investment
(b) Incompetent management i.e. inexperienced. They lack knowledge on how to raise
funds from the various sources
(c) The management may decide against issuing additional equity finance so as to
maintain control over the company.
(d) The management may decide against raising additional debt finance in order to
avoid interest payments and maintain the gearing level of the company.
(e) The management may avoid increasing equity finance by issuing more shares so as
not to dilute earnings per share (EPS).
(f) If a company is family owned, it may limit investing funds available to maintain
constant growth; hence it will be invested gradually over the life of the business.
2. Hard capital rationing:
This is where the limitation of resources is caused by external factors which are beyond
the control of the company i.e. due to systematic factors. Example of causes
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(a)
(b)
(c)
(d)
(e)
(f)

High competition for funds making the cost of borrowing to be high.

Depressed stock exchange where the companys market price per share is declining
hence its felt by the investors as Risk Company.
High cost of capital
The macro economic factors e.g. interest rates, inflation rates, unemployment and
balance of payments
Political instability
Environmental factors e.g. adverse climatic conditions that affect agricultural
companies.

Overcoming capital rationing problems

Dealing with single-period capital rationing
1. Divisible projects: we use profitability index (PI). The aim when managing capital
rationing is to maximise the NPV earned per sh.1 invested in projects. This is done
by:
(a) Calculating a PI for each project.
(b) ranking the projects according to their PI
(c) Allocating funds according to the projects rankings until they are used up.
The formula is:

2. Indivisible projects: If projects are indivisible it must be done in its entirety or not at
all. To determine the optimum use of capital investment, a trial and error approach
must be used.
3. Mutually-exclusive project: Sometimes the taking on of projects will preclude the
taking on of another, e.g. they may both require use of the same asset. In these
circumstances, each combination of investments is tried to identify which earns the
higher level of returns.
Dealing with multi-period capital rationing
Use linear programming:
A solution to a multi-period capital rationing problem cannot be found using Profitability
Index. This method can only deal with one limiting factor (i.e. one period of shortage).
Here there are a number of limiting factors (i.e. a number of periods of shortage) and
linear programming techniques must therefore be applied.
Objective functions
The linear programming method can be applied to a multi-period capital rationing
problem in one of two ways. The objective of the solution can be either:
-

to maximise the total NPV from the investment in available projects

to maximise the present value of cash flow available for dividends.

Both techniques result in the same project selections.

Dual values
The dual price is:

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the amount by which one additional unit of scarce resource would increase the value
of the objective function, or alternatively
the amount by which one fewer unit of scarce resource would decrease the value of
the objective function.

In capital rationing, the scarce resource is available funds, so the dual value expresses
the increase in the objective function gained if one more dollar became available, or the
reduction if one less dollar were invested.
The amount of the dual value varies depending on which method is used to formulate
the linear programme:
NPV method - the dual equals the change in NPV earned if sh.1 more or less is
available.
PV of dividends method - the dual equals the change in the PV of cash available to
pay dividends if sh.1 more or less is available.

Difficulties in capital budgeting

(a)
(b)
(c)

(d)

Uncertainty of variables e.g. annual cash flows, discounting rates, changes in

technology, inflation rate, changes in tax rates etc.
Lack of adequate capital to undertake all viable projects (capital rationing)
Lack of adequate information on the available investment opportunities e.g. in case
of mutually exclusive projects, NPV and IRR will have conflict in ranking of projects
under same circumstances.
Identification of all the quantifiable and non-quantifiable costs and benefits
association with a project.

Factors influencing capital expenditure decisions

1.

2.

3.

4.

5.

Availability of Funds: projects dont require the same level of funds. Some require
huge amount and having high profitability. If the company does not have adequate
funds some projects may be delayed.
Required rate of return on Investment: Every management expects a minimum
rate of return or cut-off rate on capital investment. It refers to the point below which
a project would not be accepted.
Legal requirements: The management should consider the legal provisions whileselecting a project. In the case of leather and chemical industries, there are number
of legal provisions created to protect environment pollution. Now, the management
gives much importance to legal provisions rather than cost and profit.
Ranking of the Capital Investment Proposal: Sometimes, a company has two or
more profitable projects in hand. If there is only one profitable project out of many
and huge amount is available in the hands of management, there is no need of
ranking of capital investment proposal. Ranking is necessary if there is many
profitable projects in hand and limited funds is available in the hands of
management.
Degree of Risk and Uncertainty: Every proposal involves certain risk and
uncertainty due to economic conditions, competition, demand and supply
conditions, consumer preferences etc. The degree of risk and uncertainty affects the
profitability of the project. Hence, degree of risk and uncertainty of the project is
taken into consideration for selection.

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6.

Urgency: A project may be selected immediately due to emergency or urgency. The

reason is that such immediate selection saves the life of the company i.e. survival of
a company is the primary importance than other factors.
7. Research and Development Projects: Research and Development project is highly
required for technology based industries. The reason is that there is a lot of changes
made within short period in technology. The research and development project gives
more benefits in the long run. Hence, profitability is getting less importance and
survival of business is getting much importance in the case of research and
development project.
8. Obsolescence: The replacement of existing fixed assets is compulsory since there is
an obsolescence of plant and machinery.
9. Competitors Activities: Every company should watch the activities of the
competitors. The company should take a decision by considering the activities of the
competitors. If so, the company can withstand in competition by implementing new
projects.
10. Intangible Factors: Goodwill of the company, industries relations, safety and
welfare of the employees are considered while selecting a project instead of
considering profit alone. These factors are also high responsible for selection of any
project.

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