Capital Rationing | Independent Investment

Capital Rationing | Independent Investment

Capital rationing can be defined as the process of sharing resources by investor for profitability, in essence the investor has his assets and securities shared into acceptable independent investment aimed at ensuring profitability at the close of investment the period. Put in other words, the term capital rationing is used to describe a situation in which finance available for new investment is limited to an amount that prevents acceptance of all projects with positive NPV.

Investment is assumed to be acceptable if it has positive net present value (NPV) when discounted at the market rate of interest. Capital rationing is necessary in a situation where an investor does not have enough funds available to finance all its apparently profitable investments and so the investments or projects will be selected based on the magnitude of the profitability until the scarce resources diminishes.

If projects are divisible, a fraction of a project can be undertaken if the remaining funds cannot undertake a whole project, in order to gain the fraction of the benefit attached to the project. If projects are indivisible, once the funds balance cannot take care of a whole project the project is left out because a fraction of it cannot be handled at a time.

In the case of independent projects, the projects with positive net present value (NPV) contest for the limited financial, resources. For the mutually-exclusive projects the project with the highest positive net present value (NPV) is chosen to contest along with other independent projects with positive NPV.

There are types of capital ration, they include (i) external capital rationing and (ii) internal capital rationing. When capital rationing arise due to external factors outside the control of management of a business, it is called external capital rationing. When capital ration arises due to internal constraints imposed by the management it is called internal capital rationing. The factors that can cause external capital rationing include imperfections in the capital market which make funds accessibility impossible for the investors.

Limitation of rate of growth to a manageable level can engineer internal capital rationing. There are assumptions under which capital ration can be used. They are as stated below.

1. project cash flows can be estimated with certainty
2. investors have access to perfect markets
3. investors behave consistently as rights of all the proposal are equal.
4. economic benefits are the aim of every economic activity. That is, investors are to maximize profit.

Again there are reasons why an investor may prefer capital ration to raising additional funds. The reasons are as follows;

1. The unwillingness of the investors to contribute more money to the business.
2. The investors inability to put in additional resources (funds) into the business.
3. the unwillingness of the business managers to reduce the current dividend in order to add more money to reserves account for profitable investments.
4. the difficulties faced in obtaining additional finance
5. long-term capital sources may be earmarked for other areas.
6. shortage of loanable funds
7. the net cash flow receivable from the investment may not be enough to take care of the cost of capital attached to that investment.
8. debt or equity capital floatation expenses becomes so high as to make the issue of small capital unprofitable.
9. bank lending may be restricted because of government control or regulation on credit or because the firm appears to be unattractive to the bank as a lending opportunity. That is lending institutions. consider a company too risky to be given any more credit.
10. management inability to handle huge capital or management imposes its own restriction to limit its growth and expansion.
11. raising money through the stock exchange may not be possible if share prices are at depressed level.

Single Period Capital Rationing

Capital rationing has a two-way method it can be handled, these two-ways are (i) the single-period capital rationing and then (ii) multi-period capital rationing. Capital ration which persists for only one time period is called single-period capital rationing. Capital rationing know as multi-period capital rationing is the type where there is a persistence during the periods of investment, in essence it happens over several period of time. Single period capital rationing can be done using net present value as a criterion with some modifications, such as the:

1) Net Benefit/Cost index that is, NPV/ICO index, where ICO is Initial capital outlay, and NPV is net present value.

2) Gross Benefit/Cost index, that is, TPV/ICO index where TPV is total present value and ICO is initial capital outlay. This index is also called profitability index.

3) Benefits – Costs index and so on. The higher the index, the more efficiently will capital be used.

Assumptions Under Single Period Capital Rationing

(1) Capital rationing occurs in a single period of time and that capital is fully available at all other time. That is, when a project is not undertaken as at when it should, it may not be assumed but seen to have been lost forever. There is a complete certainty about the outcome of this project so that the choice among or between projects is not affected by risk consideration.

(2) Allocation using IRR and project divisibility or indivisibility give the same result as NPV/ICO above because both produced the same ranking. It can be observed from the computations above that NPV/ICO, which is Net present value per Naira of investment gives the superior ranking to NPV method.

(3) Multi-Period Capital Rationing – Multi-period capital ration is simply the act of sharing the financial resources of an entity among competing alternatives when the capital constraint lasts for more than one period. When situation like this occurs the mathematical linear programming model is used to do the capital rationing., that is, mathematical programming is used to select the projects.

Integer programming is used if projects are not divisible and integer variables are required unlike fractions when the projects are divisible. The steps involved in linear programming start with;

1. Problem formulation: This is the statement of the objective function to be maximized or minimized. Benefit in form of NPV should be maximized while cost such as the project cost should be minimized subject to the constraints and non-negativity restrictions.
2. Making use of the linear programming problem method, either by using the graphical method or simplex method in achieving credible results or solutions. Computer based algorithm models can be used.
3. Interpretation of the optimal solution.
4. Performing the sensitivity analysis to enable the decision-maker observe what extent the optimal solution deviates from the expected level with any variation in the input data.