In this article we will discuss about:- 1. Meaning of Capital Rationing 2. Factors Leading to Capital Rationing 3. Situations of Capital Rationing.
Meaning of Capital Rationing:
Capital rationing is a situation where a constraint or budget ceiling is placed on the total size of capital expenditures during a particular period. Often firms draw up their capital budget under the assumption that the availability of financial resources is limited.
Capital rationing refers to the selection of the investment proposals in a situation of constraint on availability of capital funds, to maximize the wealth of the company by selecting those projects which will maximize overall NPV of the concern.
In capital rationing situation a company may have to forego some of the projects whose IRR is above the overall cost of the firm due to ceiling on budget allocation for the projects which are eligible for capital investment. Capital rationing refers to a situation where a company cannot undertake all positive NPV projects it has identified because of shortage of capital.
Under this situation, a decision maker is compelled to reject some of the viable projects having positive net present value because of shortage of funds. It is known as a situation involving capital rationing.
In terms of financing investment projects, the following important questions is to be answered:
(i) What would be the requirement of funds for capital investment decisions in the forthcoming planning period?
(ii) How much quantum of funds available for capital investment?
(iii) How to assign the available funds to the acceptable proposals which require more funds than are available?
The answers to the first and second questions are given with reference to the capital investment appraisal decisions made by the top management. The third question is answered with specific reference to the appraisal of investment decisions from the angle of capital rationing.
Factors Leading to Capital Rationing:
Two different types of capital rationing situation can be identified, distinguished by the source of the capital expenditure constraint.
i. External Factors:
Capital rationing may arise due to external factors like imperfections of capital market or deficiencies in market information which might have for the availability of capital.
Generally, either the capital market itself or the Government will not supply unlimited amounts of investment capital to a company, even though the company has identified investment opportunities which would be able to produce the required return. Because of these imperfections the firm may not get necessary amount of capital funds to carry out all the profitable projects.
ii. Internal Factors:
Capital rationing is also caused by internal factors which are as follows:
(i) Reluctance to take resort to financing by external equities in order to avoid assumption of further risk.
(ii) Reluctance to broaden the equity share base for fear of losing control.
(iii) Reluctance to accept some viable projects because of its inability to manage the firm in the scale of operation resulting from inclusion of all the viable projects.
The second question is answered by a reference to the capital budget.
The level of capital budget will tend to depend on the quality of investment proposals submitted to top management, in addition it will also tend to depend on the following factors:
(a) Top management philosophy towards capital spending.
(b) The outlook for future investment opportunities that may be unavailable if extensive current commitments are undertaken.
(c) The funds provided by current operations.
(d) The feasibility of acquiring additional capital through borrowing or share issues. Under capital rationing, the management has to determine not only the profitable investment opportunities but also decide to obtain that combination of the profitable projects which yields highest NPV within the available funds by ranking them according to their relative profitability. Theoretically, projects should be undertaken to the point where the return is just equal to the cost of financing these projects.
If safety and the maintaining of, say, family control are considered to be more important than additional profits, there may be a marked unwillingness to engage in external financing, and hence a limit will be placed on the amounts available for investment. Even though the enterprise may wish to raise external finance for its investment program, there are many reasons why it may be unable to do this.
(a) The enterprise’s past record and its present capital structure may make it impossible or extremely costly to raise additional debt capital.
(b) Its record may make it impossible to raise new equity capital because of low yields or even no yield.
(c) Covenants in existing loan agreements may restrict future borrowing. Further more, in the typical company, one would expect capital rationing to be largely self- imposed.
Situations of Capital Rationing:
Capital rationing decisions can be studied under the following situations:
Situation I – Projects are Divisible and Constraint is a Single Period One:
The following are the steps to be adopted for solving the problem under this situation:
(a) Calculate the profitability index of each project.
(b) Rank the projects on the basis of the profitability index calculated in (a) above.
(c) Choose the optimal combination of the projects.
Using the same data as used in the previous illustration, determine the optimal project mix on the basis of the assumption that the projects are indivisible.
By a careful inspection of the feasible combinations constructed in the above table, we can conclude that the optimal project mix is A, C and E because the aggregate of their NPVs is maximum.
Situation III: Projects are Divisible and Constraint is Multi-period one:
Under this situation, the problem of capital rationing can be solved with the help of linear programming. It is a mathematical programming approach.
It can be understood with the help of the following illustration:
Ganga Ltd. has considered seven independent projects, namely A, B, C, D, E, F, and G for implementation. The company has a capital budget of Rs. 400 lakhs. The minimum acceptable rate of return is 7%
Let us now consider the capital rationing problem.
Ranking based on NPV
The optimum set comprise of projects D and C. By implementing them with an investment of Rs. 400 lakhs (Rs. 200 + Rs. 200), the company would earn returns whose present value is Rs. 370.021 lakhs (Rs. 283.007 + Rs. 87.014).
Among the seven projects, Project C has the highest IRR of 22.1% and hence this project is selected first and its commitment of funds is Rs. 200 lakhs. The project having next best IRR is Project D (IRR = 20.7%) and its commitment of funds is also Rs. 200 lakhs.
Under the profitability index ranking projects D, A and G has scored the first three ranks with a total funds commitment of Rs. 350 lakhs. Obviously projects C, B and E which are next in the sequence of decreasing PI, cannot be selected because they cannot be accommodated from the balance of funds i.e., Rs. 50 lakhs (Rs. 400 lakhs – Rs. 350 lakhs) available for investment. Hence project F is selected to complete the optimum set. The sum of NPVs of projects D, A, G and F amounts to Rs. 368.58 lakhs.
As seem from the above illustration, the decision regarding choice of set of projects which best meets the corporate financial objective in a capital rationing situation depends upon the criterion used for selection. The present value of the returns to the enterprise is, in general, different for each of the combinations recommended by using different criteria.
There is no guarantee that one particular criterion will always give a solution by which the present value of the returns will be more than that for the combination obtained by using other criteria. In some cases NPV may result in the best solution. In some others, IRR may give the best combination of projects.
While in still others, the set of projects chosen by using PI as the criterion may help maximize the net returns to the enterprise. Sometimes two or even all the three criteria may result in the same solution, while at other times the solutions may be totally different, especially when the number of viable projects is large.