- 20 Marks
FM – L2 – Q67 – Capital rationing
Question
Yebson Plc is reviewing investment proposals that have been submitted by divisional managers. The investment funds of the company are limited to GH₵800,000 in the current year. Details of three possible investments, none of which can be delayed, are given below.
Project 1
An investment of GH₵300,000 in work station assessments. Each assessment would be on an individual employee basis and would lead to savings in labour costs from increased efficiency and from reduced absenteeism due to work-related illness. Savings in labour costs from these assessments in money terms are expected to be as follows:
| Year | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Cash flows (GH₵000) | 85 | 90 | 95 | 100 | 95 |
Project 2
An investment of GH₵450,000 in individual workstations for staff that is expected to reduce administration costs by GH₵140,800 per annum in money terms for the next five years.
Project 3
An investment of GH₵400,000 in new ticket machines. Net cash savings of GH₵120,000 per annum are expected in current price terms and these are expected to increase by 3.6% per annum due to inflation during the five-year life of the machines.
Yebson Plc has a money cost of capital of 12% and taxation should be ignored.
Required:
(a) Determine the best way for Yebson Plc to invest the available funds and calculate the resultant NPV:
(i) on the assumption that each of the three projects is divisible
(ii) on the assumption that none of the projects are divisible.
(b) Explain how the NPV investment appraisal method is applied in situations where capital is rationed.
(c) Discuss the reasons why capital rationing may arise.
Answer
(a) (i) Analysis of projects assuming they are divisible
| Year | DCF | Project 1 | Project 3 | ||
|---|---|---|---|---|---|
| 12% | Cash flow | PV | Cash flow | PV | |
| GH₵ | GH₵ | GH₵ | GH₵ | ||
| 0 | (300,000) | (300,000) | (400,000) | (400,000) | |
| 1 | 85,000 | 75,905 | 124,320 | 111,018 | |
| 2 | 90,000 | 71,730 | 128,795 | 102,650 | |
| 3 | 95,000 | 67,640 | 133,432 | 95,004 | |
| 4 | 100,000 | 63,600 | 138,236 | 87,918 | |
| 5 | 95,000 | 53,865 | 143,212 | 81,201 | |
| 32,740 | 77,791 |
Project 2 NPV at 12% = GH₵(140,800 × 3.605) – 450,000 = GH₵57,584
Project 2 profitability index = 507,584 / 450,000 = 1.13
The optimum investment schedule involves investment in projects 3 and 2:
| Project | Profitability index | Ranking | Investment | NPV |
|---|---|---|---|---|
| GH₵ | ||||
| 3 | 1.19 | 1st | 400,000 | 77,791 |
| 2 | 1.13 | 2nd | 400,000 | 51,186 |
| (57,584 × 400 / 450) | ||||
| 800,000 | 128,977 |
(ii) If the projects are assumed to be indivisible, the total combinations of projects must be considered.
| Projects | Investment | NPV |
|---|---|---|
| GH₵ | GH₵ | |
| 1 | 300,000 | 32,740 |
| 2 | 450,000 | 57,584 |
| 3 | 400,000 | 77,791 |
| 1 + 2 | 750,000 | 90,324 |
| 1 + 3 | 700,000 | 110,531 |
| 2 + 3 | 850,000 | Not feasible |
The combination of Projects 1 and 3 provides the highest NPV of GH₵110,531 within the GH₵800,000 limit.
(b) In situations where capital is rationed, the NPV investment appraisal method is applied by prioritizing projects that maximize the total NPV within the available capital constraint. This involves:
- Calculating NPV for Each Project: The NPV of each project is calculated using the company’s cost of capital to determine the value each project adds.
- Ranking Projects by Profitability Index (for Divisible Projects): For divisible projects, the profitability index (NPV per unit of capital invested) is used to rank projects. Funds are allocated to projects with the highest profitability index until the capital is exhausted.
- Evaluating Combinations (for Indivisible Projects): For indivisible projects, all feasible combinations of projects within the capital limit are evaluated to identify the combination that yields the highest total NPV.
- Maximizing NPV: The goal is to select the project or combination of projects that provides the highest total NPV, ensuring optimal use of limited funds.
This approach ensures that the company achieves the maximum financial benefit from its constrained investment resources.
(c) Capital rationing may arise due to the following reasons:
- Limited Internal Funds: The company may have insufficient retained earnings or cash reserves to finance all desirable projects, restricting available capital.
- Restricted Access to External Finance: Banks or financial institutions may impose lending limits, or the company may face high borrowing costs, limiting access to debt financing.
- Equity Constraints: Issuing new shares may be undesirable due to dilution of ownership, high flotation costs, or unfavorable market conditions, restricting equity financing.
- Management-Imposed Limits: Management may deliberately limit investment to maintain financial discipline, reduce risk, or focus on strategic priorities.
- Economic Conditions: Economic downturns or market uncertainties may reduce available capital or make financing more difficult to obtain.
- Regulatory Restrictions: Regulations or covenants in existing loan agreements may restrict the company’s ability to raise additional funds.
Capital rationing can be seen as a way of reducing the risk and uncertainty associated with investment projects, as it leads to accepting projects with greater margins of safety.
- Topic: Capital rationing
- Uploader: Samuel Duah