Capital rationing is a crucial concept in finance where companies face limited funds for investment projects. This constraint forces businesses to prioritize and select the most beneficial opportunities, balancing potential growth with financial limitations.
To tackle capital rationing, firms use techniques like the profitability index and internal rate of return. These methods help rank projects based on their financial merits, ensuring optimal allocation of scarce resources and maximizing shareholder value.
Capital Rationing
Concept of capital rationing
- Refers to the limitation of funds available for investment projects due to financial constraints
- Occurs when a company has more profitable investment opportunities than available capital (cash, debt capacity)
- Forces the company to prioritize and select the most beneficial projects based on their financial merits
- Implications of capital rationing include inability to invest in all profitable projects, potential loss of future growth opportunities (market share, competitive advantage), and increased importance of project selection and resource allocation to maximize shareholder value
Techniques for capital allocation
- Profitability index (PI) method calculates the ratio of the present value of future cash inflows to the initial investment, with projects ranked based on their PI and higher PI projects given priority
- Formula: $PI = \frac{Present\ Value\ of\ Future\ Cash\ Inflows}{Initial\ Investment}$
- Example: Project A with PI of 1.5 would be prioritized over Project B with PI of 1.2
- Internal rate of return (IRR) method determines the discount rate that makes the net present value (NPV) of a project equal to zero, with projects prioritized based on higher IRRs
- IRR is compared to the required rate of return or cost of capital (hurdle rate) to assess project attractiveness
- Example: Project A with IRR of 20% would be preferred over Project B with IRR of 15% if the cost of capital is 12%
- Combination of NPV and PI methods involves first ranking projects based on their positive NPV and then using PI to prioritize resource allocation among the positive NPV projects
- Ensures that only value-creating projects are considered and optimizes the allocation of limited funds
- Example: Among projects with positive NPV, those with higher PI would receive funding priority
Risk Analysis in Capital Budgeting
Types of investment risks
- Business risk arises from uncertainty in the projected cash flows due to changes in market conditions (demand, price), competition, or technological advancements
- Financial risk arises from the use of debt financing, which magnifies the variability of returns to shareholders (financial leverage)
- Liquidity risk refers to the difficulty in converting the investment into cash without significant loss of value (illiquid assets)
- Political and regulatory risk stems from changes in government policies, regulations (taxes, tariffs), or political instability that may affect the project's viability
Risk analysis in capital budgeting
- Sensitivity analysis assesses the impact of changes in key variables (revenue, costs) on the project's profitability, helping identify the most critical variables that affect the project's success
- Provides a range of possible outcomes based on variations in input variables (best case, worst case)
- Example: Analyzing the impact of a 10% change in sales volume on the project's NPV
- Scenario analysis evaluates the project's performance under different sets of assumptions or scenarios (base case, best case, worst case), helping understand the potential outcomes and their likelihood of occurrence
- Example: Developing scenarios based on different market growth rates and analyzing their impact on the project's IRR
- Monte Carlo simulation is a computerized technique that generates multiple random scenarios based on probability distributions of input variables, providing a more comprehensive view of project risk by considering the interrelationships among variables
- Helps in estimating the probability distribution of the project's NPV or IRR
- Example: Running 1,000 simulations to determine the likelihood of the project achieving a target NPV