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Capital Rationing

ACC 412: Management


Accounting
Week Eight

Course Lecturer:
Ben-Caleb, Egbide

Lecture Objectives

At the end of this lecture, students should


be able to
Explain the concept of Capital Rationing
Appreciate the reason(s) for capital
rationing in organizations.
Differentiate soft capital rationing from
hard capital Rationing
Apply the principle of capital rationing
to both single product and multi product
cases

What is Capital Rationing (CR)

Capital Rationing is a process of


allocating or prorating a firms funds to
selected viable Projects on the basis of
some chosen project evaluation criteria in
view of its financial constraint.

(CR)
Capital Rationing arises when there are

insufficient funds to execute all viable and


profitable projects.
CR exist when there is a financial
constraint that preclude or prevents the
acceptance of all projects with positive
Net present value (NPV)
That is when the firm is unable to initiate
all projects which are apparently profitable
because insufficient funds are available.

Causes of Capital Rationing (CR)


Capital rationing decision could be caused by either internal or external factors;

Internal

Capital Rationing: It is a financial constraint cause by


management policies. For instant, management may decide that
investment should be limited to the amount that can be financed solely
from retained earnings or kept within a given capital expenditure budget.
Bad Management; ii When management is reluctant to Dilute control; iii
when management want to maintain a stable dividend rather than using
available cash to finance investment in new projects; iv when a company set up
for itself a cut off rate that is higher than the companys cost of
capital. This
also referred to as SOFT or ARTIFICIAL CR

External Capital Rationing: This occur in an imperfect capital market,


where capital may be raised, but at increasing rate of interest: but there
will be a point where there is an absolute limit to the amount that could be
raised.
Higher interest rate; strict listing requirement; high Gearing; Restriction of
bank Lending by Government; Unwillingness on the part of the
investor to
invest because the investment is considered to be too risky. This is sometimes
referred to as HARD or REAL CR

Rationing (CR)
Soft Capital Rationing (SCR): refers to situation
were, for various reasons, the firms internally
imposes a budget ceiling on the amount of capital
expenditure. This also referred to as Internal CR
or ARTIFICIAL CR
Hard Capital Rationing (HCR): Refers to a
situation were the amount of capital investment is
restricted because of external constraints. It is
sometime refers to a external CR or REAL CR

Rationing
Single Period Capital Rationing: This occurs

when there is insufficient funds to finance all


viable projects in one period (now), but where
it is anticipated that funds will be freely
available in subsequent periods
Multi-Period Capital Rationing: This exist
when the financial limitation extends over a
number of periods or possibly indefinitely.

Concepts in Capital Rationing

Divisible Projects: projects are divisible if


the either the whole project or any fraction of it
could be undertaken. If a fractional part is
undertaken, then it is assumed that the initial
outlay and subsequent cash inflows and
outflows are reduced pro rata.

Indivisible Projects: these are projects that


must be undertaken as a whole and not in
fractions

Assumptions of Capital Rationing


(Single Period)

Financial Restriction is limited to a single

period
All project are divisible
There is a linear relationship between
NPV and Initial Outlay
Funds are always available at a cost
The risk attach to all viable projects are
the same.

Period)

Identify the amount of funds available


Identify the period of financial restriction
Calculate the NPV of all projects if not

given
Use the NPV to calculate the Benefit Cost
ratio or Profitability index
Rank the projects in descending order
Allocate the available fund

Steps in Capital Rationing

(Multi-Period)

Calculate the projects NPVs


Formulate the problem in LP terms which

means defining the objective function and


the constraints
Solve the LP problem
Interpreted the solution

Application 1

(Single-Period)

SME Limited is faced with a problem of investing


N100,000 in three projects which are all attractive
and profitable at 10% opportunity cost of capital.
Which of the following projects should be
undertaken, given the following evaluation
results:
Projects
Initial outlay NPV@10%
N
N
1
100,000
21,000
2
50,000
16,000
3
50,000
12,000

Solution to Application 1

(Single-Period)

Profitability Index = NPV/ Initial outlay


Project 1 = 21,000/100,000 = 0.21
Project 2 = 16,000/50,000 = 0.32
Project 3 = 12,000/50,000 = 0.24
Choice

PI

Required Capital

Cum Capital
outlay

Ranking

0.3
2

50,000

50,000

1st

0.2
4

50,000

100,000

2nd

0.2
1

100,000

200,000

3rd

Application 2

(Single-Period)

NUASA LTD has N1000,000 available for investment and the under listed project
which are not mutually exclusive have been identified
Project

Initial outlay(N000)
Residual Value

280 360 400 340 240


10,000 NIL NIL 5,000

NIL

Net cash flow during 6years of the project life


are:
Project A: N80,000
Project B: N160,000 for each of the 1st 3 years and N120,000 for the next 3 years
respectively
Project C: N120,000 for each of the 3 years and N160,000 for each of the remaining
years
Project D: N80,000 annually for the first 3 years beign25% less than the amount
for the next three years
Project E: first year Nil and the remaining 5 years N100,000 per annum.
The expected rate of return on capital is 15%
Required:
With supporting calculation, advise management which of the project should be
selected for investment?

Solution to Application 2

(Single-Period)

Project A
Year

Cash flow

DCF

PV

280,000

(280,000)

1-6

80,000

3.784

302720

10,000

0.432

4320

NPV

27040

PI = 27040/280,000 = 0.097
Project B
Year

Cash flow

DCF

PV

360,000

(360,000)

1-3

160,000

2.283

365280

4-6

120,000

1.501

180,120

NPV

185,400

PI = 185400/360,000 = 0.52

Solution to Application 2

(Single-Period)

Project C
Year

Cash flow

DCF

PV

400,000

(400,000)

1-3

120,000

2.283

273960

4-6

160,000

1.501

240160

NPV

114120

PI = 114120/400,000 = 0.29
Project D
Year

Cash flow

DCF

PV

340,000

(340,000)

1-3

80,000

2.283

182,640

4-6

106,667

1.501

160,107

5000

0.432

2160

NPV

(4907)

PI = 5100/340,000 = 0.015

Solution to Application 2

(Single-Period)

Project E
Year

Cash flow

DCF

PV

240,000

(240,000)

NIL

0.870

NIL

2-6

100,000

2.914

291400

NPV

51400

PI = 51400/240,000 = 0.21

Ranking Of Projects
Projects

PI

0.097

0.52

0.29

0.21

Rank

4th

1st

2nd

0.015
5th

3rd

Solution to Application 2

(Single-Period)

ALLOCATION TABLE
Ranks Proje Outlay
ct
1st

2nd

3rd

4th

5th

Available

Allocatio Cum
Balanc
n
Allocati e
on
360,00 360,000 360,000 640,00
0
0
400,00 400,000 760,000 240,00
0
0
240,00 240,000 1,000,0 NIL
0
00
280,00
0
340,00
0
funds = N1000,000

Application 3 (Multi-Period)
NESA CONSULT has identified the following
projects
Projects Yr 0
Yr 1
Yr2
N
N
N
A
(100,000) (100,000) 302,410
B
(50,000) (100,000) 218, 070
C
(200,000) 150,000 107,230
Provide a mathematical programming
formulation to assist the company in choosing
the most viable project, if capital available for
yr0 and Yr1 is limited to N170,000 and N80,000
respectively. Assume 5% cost of capital and that
the projects are divisible.

Solution to Application 3 (Multi-Period)


Project A
Years
NCF
DCF @ 5%
PV
N
N
0
(100,000) 1.00
(100,000)
1
(100,000) 0.952
(95,200)
2
302, 410 0.907
274,286
NPV
79,086
Project Bs
NCF
DCF @ 5%
PV
N
N
0
(50,000) 1.00
(50,000)
1
(100,000) 0.952
(95,200)
2
218,070 0.907
197,789
NPV
52,589

Solution to Application 3 (Multi-Period)


Project C
Years
NCF
DCF @ 5%
PV
N
N
0
(200,000) 1.00
(200,000)
1
150,000 0.952
142,800
2
107,230 0.907
97,258
NPV
40,058
LP Formulation;
Maximize: NPV= 79086A + 52589B + 40,058C
Subject to:
100,000A + 50,000B + 200,000C 170,000
100,000A + 100,000B

80,000 + 150,000C

A,B,C

A,B,C,

0 (non negativity constraint)