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 . !auses "# $ard capital rationing %# &oft capital rationing &oft 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. 'anagement may put a maximum budget limit to be spent within a specific period. (xamples)causes of soft capital rationing "# * self imposed budgetary limit where the management puts a ceiling on the maximum amount to be spent on investments. %# 'anagement may decide against issuing more e+uity finance in order to maintain control over the companys affairs by existing shareholders. ,# 'anagement may opt not to raise more e+uity so as to avoid dilution in the (arning per share. -# 'anagement may decide against raising additional debt due to the following reasons. a# /o avoid increase in interest payment commitment b# /o control the gearing or operating leverage so as to maximi0e the financial risk. 1# 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. $ard 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. !auses of hard capital rationing "# (conomic factors e.g. high interest rates and high inflation %# Perception by investors that the company is risky. 2here 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. ,# $igh competition for funds by different companies resulting into an increase in the costs of borrowing. -# 3epressed stock exchange. /he companys share market price is very low and so may find it hard to raise funds from the stock market.

Project Project Project Project

" % , -

Investment outlay 455 455 %55 -55

NPV ,55 %65 75 "55

Profitability index ".1 ".-1 ".".%1

If we had an unlimited budget we would undertake all projects and we would improve shareholder wealth bysh.615 8sum of the NPVs#. 2ith a budget of sh."555 our decisions will be different. 2e would choose project " and -. Project - is our third best option but due to constraints of funds we are forced to choose it. !apital rationing has the potential to misallocate resources. 9unds should be diverted to the highest NPV projects. NPV cannot be correctly used to rank projects with different si0es. 9or example a project may have an outlay of "5555 and an NPV of 4 while another project may have an outlay of 1 and an NPV of -. !an you say the first project is better since it has a higher NPV: /he second project has had a smaller outlay and a higher NPV as a percentage of outlay 8-)1# than the first project 84)"5555#. 2e should then use another method which captures the si0e of the investment. Profitability index is an especially useful method because it shows the profitability of each investment per currency invested. 2hen 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 " and -. 2e had a budget of "555 and we have spent only 755. 2ith the remainder we can either invest in part projects e.g. fraction of either project % or ,. 3ivisible projects /hese 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. 3ivisible projects /hese are projects which cannot be undertaken in portions. /hey 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. /he remainder can be invested in marketable securities. &ingle period capital rationing It is a situation where the company has limited amounts of funds in one investment period only. *fter that period the company can access funds from various sources e.g. issuing shares borrowing from banks or issuing bonds.

I;;<&/=*/I>N. *?! ;td.is considering investing in the following independent projects Project " % , PV of cash flow %,5555 "-"%15 "@-%15 "4%555 Initial cost %55555 "%1555 "61555 "15555 NPV ,5555 "4%15 "@%15 "%555 PI "."1 ".", "."" ".5

/he company has set a capital limit of sh.,55555. =e+uired. *dvice the management on the projects to undertake. &olution If there was no capital rationing then all the - projects would be accepted co0 they have positive NPV. $owever with capital rationing the projects have to be compared using PI index. 2ith sh.,55 555 we could have invested in three options. Invest in project "A invest in projects % and ,A invest in projects % and -. 2e will select the option that gives us the highest weighted average profitability index. * major assumption made in analysis is that the PI index of all projects is excess of one and the unused funds PI is e+ual to one. 2eighted average PI. 9or option ". "."18%55),55# B ".58"55),55# C "." 9or option %. ".",8"%1),55# B ".""8"61),55# C ".""7 9or option ,. ".",8"%1),55# B ".578"15),55# B "8%1),55# C ".5@3ecision. Invest in project % and , since this results in the highest weighted average PI. 'ultiperiod capital rationing It occurs where the company has limited amounts of funds for a longer duration of time. /he 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.