Session 4: Capital Rationing Learning Outcome
The Learners should be able to understand that always the case that when a company proposes a viable investment project the company is able to are able to finance it. Some factors limit the capital base of the firm and always there is an alternative to the investments made by firms. Important Learning Terms - Capital rationing
- Hard rationing
- Soft rationing
- Capital limiting factors
A: Capital Rationing
Many companies specify an overall limit on the total budget for capital spending. There is no conceptual justification for such budget ceiling, because all projects that enhance long run profitability should be accepted. The factors for putting limit - Net present values or IRR may strongly influence the overall budget amount
- Top management’s philosophy toward capital spending.
- Same managers are highly growth minded whereas others are not.
- The outlook for future investment opportunities that may not be feasible if extensive current commitments are undertake.
- The funds provided by the current operations less dividends.
- The feasibility of acquiring additional capital through borrowing or sale of additional stock. Lead-time and costs of financial market transactions can influence spending.
- Period of impending change in management personnel, when the status quo is maintained.
- Management attitudes toward not.
Capital Rationing occurs when a company has more amounts of capital budgeting projects with positive net present values than it has money to invest in them. Therefore, some projects that should be accepted are excluded because financial capital is limited.
This is known as artificial constraint because the management may dictate the amount to be invested for project purposes. It is also the artificial constraints because the amount is not based on the product marginal analysis in which the return for each proposal is related to the cost of capital and projects with net present values are accepted. A company may adopt a posture of capital rationing because it is fearful of too much growth or hesitant to use external sources of financing. 
Types of Capital Rationing - Hard Capital Rationing: This arises when constraints are externally determined. This will not occur under perfect market
- Soft Capital Rationing: This arises with internal, management-imposed limits on investment expenditure.
Reasons for Capital Rationing
There are basically two types of reasons of capital rationing. - External Reasons
These arise when a firm is unable to borrow from the outside. For example if the firm is under financial distress, tight credit conditions, firm has a new unproven product.
Borrowing limits are imposed by banks particularly in relation to smaller firms and individuals. - Internal Reasons
- Private owned company: Owners might decide that expansion is a trouble not worth taking. For example there may that management fear to lose their control in the company.
- Divisional Constraints: Upper management allocates a fixed amount for each division as part of the overall corporate strategy. This arise from a point of view of a department, cost centre or wholly owned subsidiary, the budgetary constraints determined by senior management or head office.
- Human Resource Limitations: Company does not have enough middle management to manage the new expansions
- Dilution: For example, there may be a reluctance to issue further equity by management fearful of losing control of the company.
- Debt Constraints: Earlier debt issues might prohibit the increase in the firms debt beyond a certain level, as stipulated in previous debt contracts. For example bondholders requiring in the bond contract, that they would accept a maximum Debt-to-Asset ratio = 40%.
Capital Rationing could be said to signal a managerial failure to convince suppliers of funds of the value of the available projects. Although there may be something in this argument, in practice it is not a well-informed judgement. Furthermore, even if there were no limits on the total amounts of available finance, in reality the price may vary with the size as well as the term of the loan. Review Questions - Explain types of capital rationing
- Why should companies undertake capital rationing? What are important factors to consider in capital rationing?
- Explain what is hard and soft capital rationing
Questions for Discussion 1. Use the information given in the following table to answer the questions that follows. 
a) What is the project payback period on each of the projects?
b) Given that you wish to use the payback rule with the cutoff period of 2 years, which project will you accept? What about 3 years cutoff period?
c) If the opportunity cost of capital is 10% which projects have positive NPVs
d) If a firm uses the discounted-payback rule, will it accept any negative NPV projects? Will it turn down to positive NPV projects? Explain. 2. Use the following table to answer the preceded questions
insert zzz3
a) Calculate the NPV for the discount rates of 0, 50 and 100 percent.
b) What is the IRR of the project? 3. CelCom Namibia Ltd. has $1 million allocated for capital expenditures. Which of the following projects should the company accept to stay within the $1 million budget? How much does the budget limit cost the company in terms of its market value? The opportunity cost of capital is 11% for each of the projects. 
4. Your staff has come up with the following revised estimates for the project which was under discussion for several weeks by the management. 
Conduct a sensitivity analysis. What are the principal uncertainties in the project? 5 . The TalkNow (T) Ltd. a telecom company is deciding whether it should go ahead with a new project, extension of coverage in Mwanza Tanzania, which will cost the company $200mil. The net cash inflow are expected to be $1,300 million, all, coming at the end of year 1. At the end of project the company estimates that $ 1,200 million should be incurred, payable at the end of year 2.
a) Plot the project's NPV profile (HINT: Calculate NPV at 0%, 10%, 80% and 450%, and possibly at other k values)
b) Should the project be accepted if k = 10%? If k = 20%? Explain your reasoning
c) Can you think of some other capital budgeting situations in which negative cash flows or at the other end of the project's life might lead to multiple IRRs? 9. What is the "Multiple IRR problem" and what condition is necessary for its existence? 10. What are the advantages and disadvantages of the Non Discounting methods of project evaluation? | 
