Capital Rationing
Critically Discuss the concept of capital Rationing and relate it to the recent and/or current situation in the capital markets. Your answer should describe the main techniques used to assess investment projects in times when available capital is in short supply.
1.1 Capital Rationing
Capital Rationing occurs when a company has more amounts of capital budgeting projects with positive net present values than it has money to invest in them. Therefore, some projects that should be accepted are excluded because financial capital is limited.
This is known as artificial constraint because the management may dictate the amount to be invested for project purposes.
It is also the artificial constraints because the amount is not based on the product marginal analysis in which the return for each proposal is related to the cost of capital and projects with net present values are accepted.
A company may adopt a posture of capital rationing because it is fearful of too much growth or hesitant to use external sources of financing.
Capital Rationing can signal a managerial failure to convince others of funds to the value of the available projects.
Many companies specify an overall limit on the total budget for capital spending.
The factors for putting limit on total budget;
2.1 Reasons for Capital Rationing
There are basically two types of reasons for capital rationing.
External Reasons
These arise when organisations such as banks are unable to borrow from the outside external sources. For example if the bank is under financial distress, tight credit conditions.
2.2 Lehman Brothers
"The collapse of Lehman came after the US Treasury refused to bail out the embattled 158-year-old bank, a crucial shift after its support in March for a Wall Street rescue of the failing Bear Stearns.
Lehman was felled by the weight of about $60 billion in toxic bad debts. It went under holding assets of $639 billion against debts of $613 billion, making it the biggest corporate bankruptcy since WorldCom collapsed in 2002.
President Bush, seeking to assuage fears yesterday, conceded, "In the short run adjustments in the financial markets can be painful". However, he added: "In the long run, I'm confident that our capital markets are flexible and resilient, and can deal with these adjustments."
(Www.business.timesonline.com, 22nd Nov 2009, 14.30)
Internal Reasons
Private owned company: Owners might decide that expansion is a trouble not worth taking. For example there may that management fear to lose their control in the company.
2.3 Kraft versus Cadbury
"UK confectioner Cadbury has rejected a £9.8bn ($16.4bn) hostile bid from US food giant Kraft. Cadbury said it had "emphatically rejected" what it saw as the "derisory" offer, which will now be put directly to its shareholders.
Kraft offered a mixture of cash and shares for each Cadbury share - the same terms it proposed in September. As Kraft shares have dropped in value since then, the bid is now worth less than the original £10.2bn approach.
Kraft's offer does not come remotely close to reflecting the true value of our company, and involves the unattractive prospect of the absorption of Cadbury into a low growth conglomerate business model," said Cadbury chairman Roger Carr.
Kraft offered 300p in cash and 0.2589 new Kraft shares for each Cadbury share."
(www.news.bbc.co.uk, 22nd Nov 2009, 16.00)
With Kraft trying to takeover Cadburys, their Directors, Investors and shareholders have fear of loosing control of the company if the expansion and buyout is complete.
Capital Rationing could signal organisational failure as previously explained with the Lehman Brothers article. Lehman brothers tried to convince secure Banks for funds of the value of their available projects of which were no value.
3.1 Types of Capital Rationing
There are two defining implications to Capital Rationing. Hard capital rationing occurs when there is limits on the fund that need to be invested externally onto the Capital Market. Lehman Brothers is a good example of that (Page 5, 1.4).
3.2 Hard Capital Rationing
If we take Lehman Brothers as topic of Hard Capital Rationing, then we can see that from there demise, they were unable to raise investment capital because the capital markets were falling and other investors deemed the company to be too risky. Hard capital Rationing is unusual to occur in most circumstances unless the occurrence of the nature is at the company's own mistakes.
Soft Capital Rationing occurs when the company's managers or directors cap a limit on their investment funds.
3.3 Soft Capital Rationing
There are reasons to which managers may restrict the investment funds and these are because:
3.4 Single Period Capital Rationing
This is where funds are monitored initially. Single Period Capital Rationing happens when the company chooses the projects of which will maximise the total NPV. This is down to the company's current status and will probably done by ranking all the projects to see which one suitable by using the profitability index or by finding the NPV. Example one shows ranking of projects by NPV
3.5 Divisible, non-deferrable investment project
Divisible projects are where any portion of the project can be sustained, where as a Non-deferrable project is when one of the projects cannot be sustained at this time but maybe at a later date. Example two shows the investment mount and the Capital Rationing Solution.
