CAPITAL RATIONING INTRODUCTION: When funds are insufficient, the firm has to choose some more profitable projects

And reject some less profitable investment proposals. Thus, because of lack of funds, The firm is able to invest in all profitable projects the extent to which the funds are sufficient.

MEANING: Capital rationing refers to a situation where the firm is constrained for external or inernal Reasons to secure the necessary funds to invest in all profitable investment proposals.

With a capital rationing constraint, the firm attempts to select the combination of investment Proposals that will provide the greatest increase in the value of the firm subject to not exceeding The budget ceilling constraint.

FINANCIAL DEFINITION: The act or practice of limiting a companies investment. That is, capital rationing occurs when a Companies management places a maximum amount on new investment, it can make over a given period of time.

Types leading to capital rationing

Two different types of capital rationing situation can be identified, distinguished by the sources of the capital expenditure constraint. External capital rationing

This mainly occurs on account of the imperfections in capital markets. Imperfections may be caused by deficiencies in market information, or by rigidities of attitude that hamper the free flow of capital. The net present value rule will not work if shareholders do not have access to the capital markets. Imperfections in capital markets alone do not invalidate use of the net present value rule. In reality, we will have very few situations where capital markets do not exist for shareholders. Internal capital rationing This is caused by self imposed restrictions by the management. Various types of constraints may be imposed. For example, it may be decide not to obtain additional funds by incurring debt. This may be a part of the firms conservative financial policy. Management may fix an arbitrary limit to the amount of funds to be invested by the divisional managers. Sometimes management may resort to capital rationing by requiring a minimum rate of return higher than the cost of capital. Whatever, may be the type of restrictions, the implication is that some of the profitable projects will have to be forgone because of the lack of funds. However, the net present value rule will work since shareholders can borrow or lend in the capital markets. It is quite difficult sometimes justify the internal rationing. But generally it is used as a means of financial controls. In a divisional set up, the divisional managers may overstate their investment requirements. One way of forcing them to carefully assess their investment opportunities and set priorities is to put upper limits to their capital expenditures. Similarly, a company may put investment limits if it finds itself incapable of coping with the strains and organizational problems of a fast growth

Capital Rationing
Note:
Capital rationing exists when an artificial constraint is placed on the amount of funds that can be invested. In this case, a firm may be confronted with more desirable projects than it is willing to finance. A wealth maximizing firm would not engage in capital rationing.

Capital Rationing: An Example

(Firms Cost of Capital = 12%)
Independent projects ranked according to their IRRs: Project Project Size IRR E $20,000 21.0% B 25,000 19.0 G 25,000 18.0 H 10,000 17.5 D 25,000 16.5 A 15,000 14.0 F 15,000 11.0 C 30,000 10.0

Capital Rationing Example (Continued)

No Capital Rationing - Only projects F and C would be rejected. The firms capital budget would be $120,000. Capital Rationing - Suppose the capital budget is constrained to be $80,000. Using the IRR criterion, only projects E, B, G, and H, would be accepted, even though projects D and A would also add value to the firm. Also note, however, that a theoretical optimum could be reached only be evaluating all possible combinations of projects in order to determine the portfolio of projects with the highest NPV.

Required Returns for Individual Projects That Vary in Risk Levels

Higher hurdle rates should be used for projects that are riskier than the existing firm, and lower hurdle rates should be used for lower risk projects. Measuring risk and specifying the tradeoff between required return and risk, however, are indeed difficult endeavors. Interested students should read Chapter 13 entitled Risk and Capital Budgeting.