© 2000 John Petroff
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© 2000 John Petroff |
6)- Capital rationing
An important general rule of corporate finance is that each project must be chosen on the basis of its own merits, irrespective of financing. The two decisions - selection of best project and selection of appropriate method of financing - must be studied separately because the proper financing source mix will change over time and must be independent of projects that do not change once started. Exceptions to this rule must be made in the cases of either leasing or term loans backed by mortgage.
Projects are selected on the basis of their NPV contribution to the overall optimum combination of projects. Often, if there are more worthwhile projects than funds available, this is looked upon as capital rationing. The restriction may indeed come from an inability or an unwillingness of the firm to find additional sources of capital: for instance, because of tight money policy, capital market slump, heavy debt already assumed by the company, or because the current owners do not want to risk losing control over the company (if new share had to be issued). However, most often, the justification for capital rationing is not financial in nature, but comes from other factors. For instance, the firm cannot find an adequate number of qualified employees, new sources of raw materials, or an assortment of specialized equipment. Also, undertaking a large number of new projects may be too disruptive for a firm, and the number or size is deliberately scale back to a manageable dimension. Or, an entry into a new market may need to be on small scale initially (in order to avoid such a level of commercial risk and retaliation that the firm would not know how to handle it).
We return to the example of the projects of Zee Company. From the previous analysis, it was possible to eliminate three projects of the nine initially proposed: project 9 because it has a negative NPV, and trucks1 and 3 because the purchase of truck 2 was more beneficial in the long run. The remaining projects are presented in Table T-10.12.
The sum of the initial outlays of the six remaining projects amounts to $ 2.715 millions which is more than the $ 2.5 millions the company is capable of borrowing. This means that one or more project(s) must be scratched. This is a problem of constrained optimization. But, before we address the problem itself, let us identify two additional aspects of the problem. First, we must exclude the purchase of the truck from the analysis because this is a mandatory investment: the company would not be able to operate without it. The initial outlay must therefore be taken out of the funds available, and the capital constraint becomes $ 2.470 millions. Second, we observe that there is another constraint: because the firm will not be able to borrow again for the next ten years; therefore, in no future year can there be a sum of cash flows that is negative. But this is precisely what may happen in year 2006 if we retain project 7 with a cash outlay of 0.300 millions in that year. Thus, the problem must now be respecified. A problem of constrained optimization is best studied with the help of linear programming which is undertaken next.
See review questions Q-10E6.1 through Q-10E6.6.
See research assignment R-10E6.1.
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