AFMP4
Syllabus B. Advanced Investment Appraisal B1. Discounted cash flow techniques

B1aiii. Capital rationing - Single period- Types 2 / 14

Syllabus B1aiii)

Evaluate the potential value added to an organisation arising from a specified capital investment project or portfolio using the net present value (NPV) model.

Project modelling should include explicit treatment and discussion of:

iii) Single period capital rationing.

Capital rationing - Types

Shareholder wealth is maximised by taking on positive NPV projects. However, capital is not always available to allow this to happen.

In a perfect capital market there is always finance available - in reality there is not, there are 2 reasons for this:

HARD CAPITAL RATIONING

This is due to external factors such as banks won’t lend any more - why?

Reasons for Hard Capital Rationing

  1. Industry wide factor (recession?)

  2. Company has no/poor track record

  3. Company has too low credit rating

  4. Company has no assets to secure the loan

  5. Capital in short supply (crowded out by government borrowing)

SOFT CAPITAL RATIONING

Company imposes it’s own spending restriction. (This goes against the concept of shareholder maximisation - which occurs by always investing in positive NVP projects ) - why?

Reasons for Soft Capital Rationing

  1. Limited management skills in new area

  2. Want to limit exposure and focus on profitability of small number of projects

  3. The costs of raising the finance relatively high

  4. No wish to lose control or reduce EPS by issuing shares

  5. Wish to maintain s high interest cover ratio

  6. “Internal Capital market” - deliberately restricting funds so competing projects become more efficient