54411221 capital rationing
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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
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This mainly occurs on account of the imperfections in capital markets.Imperfections may be caused by deficiencies in market information, or by rigiditiesof attitude that hamper the free flow of capital. The net present value rule will notwork if shareholders do not have access to the capital markets. Imperfections incapital 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 forshareholders.
Internal capital rationing
This is caused by self imposed restrictions by the management. Various types ofconstraints may be imposed. For example, it may be decide not to obtain additionalfunds 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 capitalrationing 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 thecapital markets.
It is quite difficult sometimes justify the internal rationing. But generally it is usedas 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 theircapital expenditures. Similarly, a company may put investment limits if it findsitself incapable of coping with the strains and organizational problems of a fastgrowth
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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
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Capital Rationing Example (Continued)
No Capital Rationing - Only projects F and C wouldbe 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 theportfolio 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.
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