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Capital Rationing

A firm maximizes its shareholders wealth by accepting every project that has a positive net present value. But this assumes that the firm can raise the funds needed to pay for these investments. This is usually a good assumption, particularly for major firms which can raise very large sums of money on fair terms and short notice. Why then does top management sometimes tell subordinates that capital is limited and that they may not exceed a specified amount of capital spending? There are two reasons.

SOFT RATIONING

For many firms the limits on capital funds are soft. By this we mean that the capital rationing is not imposed by investors. Instead the limits are imposed by top management. For example, suppose that you are an ambitious, upwardly mobile junior manager. You are keen to expand your part of the business and as a result you tend to overstate the investment opportunities. Rather than trying to determine which of your many bright ideas really are worthwhile, upper management may find it simpler to impose a limit on the amount that you and other junior managers can spend. This limit forces you to set your own priorities.

Even if capital is not rationed, other resources may be. For example, very rapid growth can place considerable strains on management and the organization. A somewhat rough-and-ready response to this problem is to ration the amount of capital that the firm spends.

HARD RATIONING

Soft rationing should never cost the firm anything. If the limits on investment become so tight that truly good projects are being passed up, then upper management should raise more money and relax the limits it has imposed on capital spending. But what if there is hard rationing, meaning that the firm actually cannot raise the money it needs? In that case, it may be forced to pass up positive-NPV projects. With hard rationing you may still be interested in net present value, but you now need to select the package of projects which is within the company s resources and yet gives the highest net present value.

Let us illustrate. Suppose that the opportunity cost of capital is 10 percent, that the company has total resources of $20 million, and that it is presented with the following project proposals:

All five projects have a positive NPV. Therefore, if there were no shortage of capital, the firm would like to accept all five proposals. But with only $20 million available, the firm needs to find the package that gives the highest possible NPV within the budget. The solution is to pick the projects that give the highest net present value per dollar of investment. The ratio of net present value to initial investment is known as the profitability index.9

For our five projects the profitability index is calculated as follows

Project N offers the highest ratio of net present value to investment (0.43) and therefore N is picked first. Next come projects L and O, which tie with a ratio of 0.33, and after them comes P. These four projects exactly use up the $20 million budget. Between them they offer shareholders the highest attainable gain in wealth.10

PITFALLS OF THE PROFITABILITY INDEX

The profitability index is sometimes used to rank projects even when there is no soft or hard capital rationing. In this case the unwary user may be led to favor small projects over larger projects with higher NPVs. The profitability index was designed to select the projects with the most bang per buck the greatest NPV per dollar spent. That s the right objective when bucks are limited. When they are not, a bigger bang is always better than a smaller one, even when more bucks are spent. Self-Test 10 is a numerical example.

PROFITABILITY INDEX Ratio of present value to initial investment.

CAPITAL RATIONING Limit set on the amount of funds available for investment.