Class Notes Capital Rationing Sir Saud Tariq ST Academy

8.
Capital Rationing
CFAP 4 Business Finance Decisions (BFD)
Sir SAUD TARIQ
Capital Rationing
Capital rationing is a situation in which a company has a limited amount of capital to invest in
potential projects, such that the different possible investments need to be compared with one
another in order to allocate the capital available most effectively.
Soft capital rationing is brought about by internal factors and decisions by management.
Hard capital rationing is brought about by external factors, such as limited availability of new
external finance.
Soft capital rationing may arise for one of the following reasons.
(a) Management may be reluctant to issue additional share capital because of concern that
this may lead to outsiders gaining control of the business.
(b) Management may be unwilling to issue additional share capital if it will lead to a dilution
of earnings per share.
(c) Management may not want to raise additional debt capital because they do not wish to be
committed to large fixed interest payments.
(d) Management may wish to limit investment to a level that can be financed solely from
retained earnings.
Hard capital rationing may arise for one of the following reasons.
(a) Raising new finance through the stock market may not be possible if share prices are
depressed.
(b) There may be restrictions on bank lending due to government control.
(c) Lending institutions may consider an organisation to be too risky to be granted further loan
facilities.
(d) The costs associated with making small issues of capital may be too great.
Relaxation of capital constraints

a) It might seek joint venture partners with which to share projects.
b) As an alternative to direct investment in a project, the company may be able to consider a
licensing or franchising agreement with another enterprise, under which the
licensor/franchisor company would receive royalties.
c) It may be possible to contract out parts of a project to reduce the initial capital outlay
required.
d) The company may seek new alternative sources of capital (subject to any restrictions
which apply to it):
 Venture capital
 Debt finance secured on the assets of the project
 Sale and leaseback of property or equipment (see the next chapter)
 Grant aid
 More effective capital management
When capital rationing occurs in a single period, projects are ranked in terms of profitability
index. This is the ratio of the NPV of a project to its investment cost. The projects with the
highest ratios should be selected for investment.
For Lectures visit sta.saudtariq.com 1 Sir Saud Tariq (CAF 8, BFD CFAP 4)
8. Capital Rationing
Sir SAUD TARIQ
Question 1:
Ayub Ltd is considering four projects, W, X, Y and Z but only had $60,000. Relevant details are:
Project Investment Present value of NPV
required cash inflows
$ $ $
W (10,000) 11,240 1,240
X (20,000) 20,991 991
Y (30,000) 32,230 2,230
Z (40,000) 43,801 3,801
Required:
a) Which projects should be selected if all projects are divisible.
b) Which projects should be selected if all projects are indivisible.
Solution:
Profitability Ranking
Investment Present value index as per Ranking
Project required of cash inflows NPV (PI) NPV as per PI
$ $ $
W (10,000) 11,240 1,240 1.12 3 1
X (20,000) 20,991 991 1.05 4 4
Y (30,000) 32,230 2,230 1.07 2 3
Z (40,000) 43,801 3,801 1.10 1 2
Project Priority Outlay NPV

$ $
W 1st 10,000 1,240
Z 2nd 40,000 3,801
Y (balance) 3rd 10,000 743 (1/3 of $2,230)
60,000 5,784
Question 2)
JNT Ltd, has identified five investment opportunities. The Cash flows associated with the projects are as
follows.
Project Year 0 Year 1 Year 2 Year 3
$'000 $'000 $'000 $'000
A (105) (105) 140 175
B (210) - - 420
C (245) 70 70 140
D (70) (140) 140 182
E - (175) 350 -
Requirements:
a) Rank the projects accordingly to their desirability on the assumption that they are mutually
exclusive and funds are freely available to JNT Ltd. plc at cost of capital of 10%.
(3 marks)
Sir SAUD TARIQ
b) Assume that the projects are independent and divisible, and that capital available for investment at
Year 0 is restricted to $350,000. Thereafter funds are expected to be freely available at the cost of
capital.
(3 marks)
c) Now assume that the projects are independent and divisible, and investment funds are only limited
at Year 1 to $280,000. Which projects should be accepted and what is the total NPV available to the
firm?
(4 marks)
(10 marks)
Question 3) ACCA Kit
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HW: Q4) ACCA Kit
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Question 5) June 2014 ACCA F9 Q1
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Question 6) Summer 2007 Q1 BFD
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HW: Question 8) Winter 2014 Q1
Question 9) Winter 2016 Q3
Sir SAUD TARIQ
Solution – Capital Rationing
Solution Q4) ACCA Kit
Sir SAUD TARIQ
Solution Question 5) June 2014 Q1
Other points can be referred from pg1 of handout.
Sir SAUD TARIQ
Sir SAUD TARIQ
Sir SAUD TARIQ
HW: Question 8) Winter 2014 Q1
Sir SAUD TARIQ
Question 9) Winter 2016 Q3

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8.

Relaxation of capital constraints

Project Priority Outlay NPV

Question 3) ACCA Kit

Question 7) Summer 2012 Q2 BFD

Question 9) Winter 2016 Q3

Other points can be referred from pg1 of handout.

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