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Understanding Capital Rationing Techniques

Capital rationing is a method used to allocate limited funds among profitable investments, categorized into soft and hard capital rationing. Projects can be divisible or indivisible, with selection methods based on probability index or NPV techniques. An example illustrates how to choose the best combination of projects under both divisible and indivisible scenarios, ultimately selecting projects D, E, and a portion of G for maximum NPV.

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31 views4 pages

Understanding Capital Rationing Techniques

Capital rationing is a method used to allocate limited funds among profitable investments, categorized into soft and hard capital rationing. Projects can be divisible or indivisible, with selection methods based on probability index or NPV techniques. An example illustrates how to choose the best combination of projects under both divisible and indivisible scenarios, ultimately selecting projects D, E, and a portion of G for maximum NPV.

Uploaded by

Amos
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

CAPITAL RATIONING

Refers to a technique used to allocate funds among profitable investments in circumstances


where a firm has limitations in its capital Expenditure budget.
Under capital rationing, only a few of the profitable projects are implemented due to lack of
funds.
There are two types of capital rationing
●​ Soft capital rationing
●​ Hard capital rationing.

Soft capital rationing


Arises as a result of limitation in the level of capital caused by factors within the organization
and these can be addressed. For example; the risk perception of management, internal borrowing
limit

Hard capital rationing


Arises as a result of limitation in the level of capital caused by external factors. For example;
restrictions in loan agreements, lack of functional capital markets, high cost of capital.

Capital rationing projects may also be categorized as,


●​ Divisible projects
●​ Indivisible projects.

Divisible projects
Are those projects that can be implemented in parts. Divisible projects are selected using the
probability index technique.

Indivisible projects
Are expected to be implemented in a whole (100%). Indivisible projects are selected using the
NPV technique, by combining a number of projects that give the highest NPV.

Example
ABC incorporation has a capital Expenditure ceiling amounting to shs. 200,000,000 in a given
Financial year, a company has evaluated a total of 7 independent projects as indicated in the table
below.

Project Cost NPV

A 20,000,000 12,000,000

B 40,000,000 30,000,000

C 75,000,000 100,000,000

D 100,000,000 220,000,000

E 80,000,000 150,000,000

F 60,000,000 (20,000,000)

G 150,000,000 275,000,000

Required: Assuming the projects are not divisible, select the best combination to be taken.

Solution

Projects Cost NPV Rank

A+B+C 135,000,000 142,000,000 7

A+B+E 140,000,000 192,000,000 6

A+D+E 200,000,000 382,000,000 1

B+G 190,000,000 305,000,000 3

A+C+D 195,000,000 332,000,000 2

A+G 170,000,000 287,000,000 4

B+C+E 195,000,000 280,000,000 5

So project A + D + E will be taken


Workings
A+B+C
Cost = 20+40+75
Cost = 135M

NPV = 12 + 30 + 100
NPV = 142M

A+B+E
Cost = 20+40+80
Cost = 140M

NPV = 12+30+150
NPV = 192M

CAPITAL RATIONING FOR DIVISIBLE PROJECTS


Using the above example, assuming the projects are divisible, select the best alternative.
Solution

Projects Cost NPV PI ( NPV ÷ cost ) + 1 PI Rank

A 20,000,000 12,000,000 1.6 6

B 40,000,000 30,000,000 1.75 5

C 75,000,000 100,000,000 2.33 4

D 100,000,000 220,000,000 3.2 1

E 80,000,000 150,000,000 2.875 2

F 60,000,000 (20,000,000) Reject -

G 150,000,000 275,000,000 2.83 3


Get the one with rank 1 and 2 that's project D and E, their total cost is 100 + 80 = 180M, but the
total expenditure is 200M

The project with the third, G, rank has the total cost of 150M

So cost is:
Cost = ( remaining balance ÷ cost of G ) * NPV of G
Cost = (20 ÷ 150 ) * 275
Cost = 36.7M
Cost = 37M

D + E + part of G
NPV = 220 + 150 + 37
NPV = 470M

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