Capital Rationing
Contents |
Introduction
- Soft Rationing - Internal limit on capital expenditure
- Hard capital Rationing - Imposed by financial organization
Ranking NPV projects based upon profitability index is one way to maximize the capital
eg Take the PV (not netted by the initial investment) and divide it by the investment, so if PV = 3.25 and Investment was 2.5 then the profitability index is 1.3. Do that for all projects and undertaken all the projects up to the capital limit. NPV can be used and this will not affect the rankings.
Capital Rationing Decisions
Normally, using NPV all projects with a positive NPV should be undertaken and if two projects are mutually exclusive we choose the one with the highest positive NPV. However, in practice there may often be insufficient funds available to undertake all viable project and without additional external financing the amount that can be invested is limited to the available retained profits plus the unused borrowing capacity. It is not uncommon for divisional managers to be told that they have to ‘compete’ for the limited funds that Group can make available. Consequently divisional managers not only need to be able to apply investment appraisal techniques to their prospective projects competently, they must also be good at presenting their projects and ‘winning’ the funds from Group.
Capital rationing adds an extra complication to investment appraisal as we must reject viable projects due to lack of funds and find a way to determine the combination of projects that will maximise the firm’s NPV within the constraint on capital. Simply ranking projects in terms of absolute NPV is not effective as we must consider the size of the NPV in relation to the capital invested. If projects are independent and divisible we simply use the profitability index to rank projects and accept projects with the highest profitability index first, moving to those with a lower profitability index, until all the funds are used up.
Example X Ltd has identified five independent projects but is rationed to a maximum of $200m this year (year 0). The capital limitation will be removed from year one onwards. Details of the projects and their NPV are as follows:
| Project | A | B | C | D | E |
| Year | $M | $M | $M | $M | $M |
| 0 | -100 | -500 | -100 | -50 | -125 |
| 1 | 20 | -20 | 60 | 20 | 70 |
| 2 | 40 | 100 | 60 | 30 | 60 |
| 3 | 60 | 125 | 100 | 20 | 75 |
| 4 | 80 | 140 | 0 | 40 | 70 |
| NPV | 50.96 | 104 | 79.26 | 35.32 | 92.38 |
| Project | A | B | C | D | E |
| Year | $M | $M | $M | $M | $M |
| NPV | 50.96 | 104 | 79.26 | 35.32 | 92.38 |
| Initial Investment | 100 | 500 | 100 | 50 | 125 |
| Profitability Index | 0.51 | 0.69 | 0.79 | 0.71 | 0.74 |
| Ranking | 5 | 4 | 1 | 3 | 2 |
To maximize the the capital you would take 100% of Project C plus invest the balance in Project E (about 80%). The NPV would be $79.26 plus 92.38*0.8 = $153.17.
Mutually Exclusive Projects
If projects C and E are mutually exclusive then you would do the ranking again an include C but not E and then include E but not C. Under that scenario C,D and 33% of E is preferred.
Non Divisble Projects
You can not build half an airliner so it may not be possible to invest partial sums. In that case you would add up the NPV's of Project Combinations that are at least but no more than $200. In that case Project B and D cost $200 million and return an NPV of $139.32m
- Note that the IRR would be of no use to us in a capital rationing
situation as it is not an absolute measure and cannot be used to rank projects.
- Note this assumes all projects start at the same time. Multi-periods capital rationaing requires the use of linear programming to determine the best combination.
Limitations
- Projects do not all start at the same time so it is difficult to identify a specific capital amount.
- The NPV's may have differing income streams and risks
- If the investment outlays are above the capital limit you may have to undertake only part of the project if that is feasible or the number of whole projects that most closely utilizes the capital. See NPV
If there are mutually exclusive projects, for instance you cannot do E if you do C then pursue the projects based upon the profitability index up to the Capital Rationing limit. There all combinations should be tried to determine the best combination. However, the combination must exactly equal the capital rationing limit.
