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Investment Appraisal (Capital rationing)
Home Level 2 2.4 Financial Management Archive by Category "Investment Appraisal (Capital rationing)"

Category: Investment Appraisal (Capital rationing)

2.4 Financial ManagementInvestment Appraisal (Capital rationing)Level 2

Nov 2020 Q4 b.

In the coming years, the company is likely to face restrictions on financing for capital investments.

Required:
i) Distinguish between soft capital rationing and hard capital rationing. (2 marks)

View Solution

Soft capital rationing is when the restriction on capital allocation to capital projects is due to internally imposed constraints such as managerial decisions.

Hard capital rationing is when the restriction on capital allocation to capital projects is due to the difficulty in raising capital from the capital market.

ii) Advice the managers of the company on THREE (3) practical ways of dealing with capital rationing. (3 marks)

View Solution

Practical ways of dealing with capital rationing include the following:

  • Delay the start of projects that could not be financed immediately
  • Seek joint venture with other firms to reduce the capital requirements on the firm
  • Subcontract portions of the investment phase with the agreement that subcontractors pre-finance

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2.4 Financial ManagementInvestment Appraisal (Capital rationing)Level 2

May 2016 Q1 c&d

 

ABC Ltd is considering five projects for the coming financial year. Four of the projects have undergone financial appraisal (see the table below).

Project PA205 entails an immediate capital investment of GH¢150,000 and will produce the following annual net cash flows in real terms:

Expected general rate of inflation is 15% and the company’s money required rate of return is 25%.

Required:

c) Suppose in the coming financial year, only GH¢200,000 of finance will be available for investments but the capital constraint will ease afterwards. Advise the company on which project(s) to implement in the coming year if the projects are:       (6 marks)
i) Independent and divisible

View Solution

When a firm faces capital rationing for a single period and projects are independent and divisible, funds may be allocated to projects based on the profitability index rankings.

That is the company should invest fully in projects PA201, PA203, and PA202; 31.76% in PA204 (27,000/85,000); and nothing in PA205 which is at the bottom of the ranking. The optimum aggregate NPV is GHS279,949.
Workings:
* NPV from PA204 is its NPV multiplied by the proportion of the investment requirement the company will allocate funds to (i.e. GHS95,400 x 31.76%).

ii) Independent and indivisible

View Solution

Here we consider a combination of the projects and select the combination that will produce the highest combined NPV. Any unused funds may be invested externally (e.g. in securities).

The company should invest in projects PA201, PA202 and PA203 to earn the highest combined NPV of GHS249,650. The unused funds of GHS27,000 should be invested externally.

d) When management rejects projects with positive net present value because of capital constraints, they lose opportunities to enhance the value of shareholders. Suggest three practical ways of dealing with capital rationing so as not to discard projects with positive net present value.                                                                                                                                       (6 marks)

View Solution

  • Seek joint venture partners with which to share projects investment requirement.
  • Use licensing or franchising arrangement with other entities to get the product produced and sold. The firm will earn royalties while avoiding financing of the investment requirements.
  • Contract out parts of the project to subcontractors who would finance the project in advance.
  • Seek alternative financing such as venture capital and asset securitization.
  • Seek grants or aid from government or organizations if the project advances an object the government or such organizations promote or seek to achieve.

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