Chapter 22 -- Capital RationingChapter 22 -- Capital Rationing

Capital Market imposed capital rationing Intersects the cost of capital line at a

vertical point due to information asymmetry

Investors simply may not be willing to provide more money to the company because they do not believe more growth is good

Reasons for Capital RationingReasons for Capital Rationing

Management policy Common practice – 72% of companies Tool for allocating funds in support of

strategy Control problems if more securities are sold Limit risk by limiting growth

Reasons for Capital RationingReasons for Capital Rationing

Management policy (continued) Belief that competition forces the best

projects to the top of the heap Uncertainty about the actual cost of capital Surrogate for dealing with other scarce

resources, such as management talent

Capital Rationing and NPVCapital Rationing and NPV

Use the rate over the constrained period and then the cost of capital

When NPV conflicts with IRR use the NPV method

Single-period Capital RationingSingle-period Capital Rationing

No capital rationing expected after this year’s selections are made

Wealth maximization rule is to allocate scarce capital so as to maximize total NPV using the standard NPV evaluation methods

Multi-period Capital RationingMulti-period Capital Rationing

Allocate capital so as to maximize wealth as of the end of the capital rationing period (TWc)

c n

TWc = CFt(1+Rt)c-t + CFt/(1+k)t-c – I0(1+R0)t

t=1 t=c+1

Where c is the number of periods of capital rationing, CFt is cash flow in period t, Rt is the reinvestment opportunity rate for period t, k is the required return (WACC), and I0 is the initial investment.

Multiperiod Capital RationingMultiperiod Capital Rationing

If capital rationing will last as long as proposed investments, cost of capital will remain constant, and reinvestment opportunity rate will remain constant, NPV with capital rationing (NPVR) =

n

NPVR = CFt/(1+R)t – I0

t=1

Where R is the reinvestment opportunity rate

IRR Rankings in Capital IRR Rankings in Capital RationingRationing

IRR ranking will lead to correct selection if capital rationing will last as long as the proposed investment, R will be the same each period, and will exceed the cost of capital, and R is the rate of return on the highest rejected investment.

Multiple IRRs Dorfman shows that if the project has more than one

IRR, the highest IRR is the rate at which capital will grow

Profitability Index and Capitial Profitability Index and Capitial RationingRationing

Useful only for single-period rationing

Mutually Exclusive Projects and Mutually Exclusive Projects and Capital RationingCapital Rationing

General solution requires mathematical programming

If the company has enough capital this period to accept all investments above the internal reinvestment rate, R, the problem can be simplified to maximizing NPV using R as the discount rate