INVESTMENT DECISIONS AND STRATEGIES
5.9 INVESTMENT EVALUATION AND CAPITAL RATIONING
We have seen that, under the somewhat limiting assumptions specified, the wealth of a firm’s shareholders is maximised if the firm accepts all investment proposals that have positive net present values. Alternatively, the NPV decision rule may be restated as:
accept investments that offer rates of return in excess of their opportunity costs of capi- tal. The opportunity cost of capital is the return shareholders could obtain for the same level of risk by investing their capital elsewhere. Implicit in the NPV decision rule is the notion that capital is always available at some cost to finance investment opportunities.
In this section, we relax another assumption of perfect capital markets to include the situation where firms are restricted from undertaking all the investments offering posi- tive net present values. Although individual projects cannot be accepted/rejected on the basis of the NPV rule, the essential problem remains: namely, to determine the package of investment projects that offers the highest total net present value to the shareholders.
■ The nature of constraints on investment
In imperfect markets, the capital budgeting problem may involve the allocation of scarce resources among competing, economically desirable projects, not all of which can be undertaken. This capital rationingapplies equally to non-capital, as well as cap- ital, constraints. For example, the resource constraint may be the availability of skilled labour, management time or working capital requirements. Investment constraints may even arise from the insistence that top management appraise and approve all capital projects, thus creating a backlog of investment proposals.
■ Hard and soft rationing
Capital rationing may arise either because a firm cannot obtain funds at market rates of return, or because of internally imposed financial constraints by management.
Externally imposed constraints are referred to as hard rationing and internally imposed constraints as soft rationing.
The Wilson Committee (1980) found no evidence of any general shortage of finance for industry at prevailing rates of interest and levels of demand. A survey of managers (Pike 1983) found that:
1 The problem of low investment essentially derives not from a shortage of finance but from an inadequate demand for funds.
2 Capital constraints, where they exist, tend to be internally imposed rather than externally imposed by the capital market.
3 Capital constraints are more acutely experienced by smaller, less profitable and higher-risk firms.
■ Soft rationing
Why should the internal management of a company wish to impose a capital expendi- ture constraint that may actually result in the sacrifice of wealth-creating projects? Soft
Self-assessment activity 5.5
Take another look at the graphs in Figure 5.2. How would you explain to a manager that Project X, with the higher IRR, is actually less attractive than Project Y?
(Answer in Appendix A at the back of the book)
capital rationing
The process of allocating capital to projects where there is insuf- ficient capital to fund all value- creating proposals
rationing may arise because of the following:
1 Management sets maximum limits on borrowing and is unable or unwilling to raise additional equity capital in the short term. Investment is restricted to internally gen- erated funds.
2 Management pursues a policy of stable growth rather than a fluctuating growth pattern with its attendant problems.
3 Management imposes divisional ceilings by way of annual capital budgets.
4 Management is highly risk-averse and operates a rationing process to select only highly profitable projects, hoping to reduce the number of project failures.
The capital budget forms an essential element of the company’s complex planning and control process. It may sometimes be expedient for capital expenditure to be restricted – in the short term – to permit the proper planning and control of the organ- isation. Divisional investment ceilings also provide a simple, if somewhat crude, method of dealing with biased cash flow forecasts. Where, for example, a division is in the habit of creating numbers to justify the projects it wishes to implement, the insti- tution of capital budget ceilings forces divisional management to set its own priorities and to select those offering highest returns.
It is clear that capital rationing can be explained, in part, by imperfections in both the capital and labour markets and agency costs arising from the separation of own- ership from management. Of particular relevance are the problems of information asymmetryand transaction costs.
Information asymmetry
Shareholders and other investors in a business do not possess all the information available to management. Nor do they always have the necessary expertise to appreciate fully the information they do receive. Capital rationing may arise because senior managers, con- vinced that their set of investment proposals is wealth-creating, cannot convince a more sceptical group of potential investors who have far less information on which to make an assessment and who may be influenced by the company’s recent performance record.
Transaction costs
The issuing and other costs associated with raising long-term capital do not vary in direct proportion to the amount raised. Corporate treasurers in large organisations will not want to go to the capital market each year for relatively small sums of money if the costs can be significantly reduced by raising much larger sums at less frequent intervals.
Capital rationing is therefore a distinct possibility in the intervening years, although this usually means delaying the start date for investments rather than outright rejection.
■ One-period capital rationing in Mervtech plc
The simplest form of capital rationing arises when financial limits are imposed for a sin- gle period. For that period of time, the amount of funds available becomes the limiting factor. The manufacturing division of Mervtech plc has been set an upper limit on cap- ital spending for the coming year of £20 million. It is not normal practice for the group to set investment ceilings, and it is anticipated that the capital constraint will not extend into future years. Assuming a cost of capital of 10 per cent, which of the investment opportunities set out in Table 5.8 should divisional management select?
In the absence of any financial constraint, projects A–D, each with positive net pres- ent values, would be selected. Once this information has been communicated to investors, the total stock market value would, in theory at least, increase by £44 mil- lion – the sum of their net present values.
However, a financial constraint may prevent the selection of all profitable projects.
If so, it becomes necessary to select the investment package that offers the highest net
present value within the £20 million expenditure limit. A simple method of selecting projects under these circumstances is the profitability index. Recall that this measure is defined as:
Project selection is made on the basis of the highest ratio of present value to invest- ment outlay. This method is valuable under conditions of capital rationing because it focuses attention on the net present value of each project relative to the scarce resource required to undertake it. Appraising projects according to the NPV per £1 of invest- ment outlay can give different rankings from those obtained from application of the NPV rule. For example, while in the absence of capital rationing, project A ranks high- est (using the NPV rule), project B ranks highest when funds are limited, as shown in Table 5.9. Assuming project independence and infinite divisibility, divisional manage- ment will obtain the maximum net present value from its £20 million investment expenditure permitted by accepting projects B and D in total and £7 million or 7/15 of project A.
However, the profitability index rarely offers optimal solutions in practice. First, few investment projects possess the attribute of divisibility. Where it is possible for projects to be scaled down to meet expenditure limits, this is frequently at the expense of profitability. Let us suppose that projects are not capable of division. How would this affect the selection problem? The best combination of projects now becomes A and B, giving a total net present value of £23 million. Project D, which ranked above A using the profitability index, is now excluded. Even more fundamental than this, how- ever, is the limitation that the profitability index is appropriate only when capital rationing is restricted to a single period. This is not usually the case. Firms experienc- ing either hard or soft capital rationing tend to experience it over a number of periods.
In summary, the profitability index provides a convenient method of selecting proj- ects under conditions of capital rationing when investment projects are divisible and independent, and when only one period is subject to a resource constraint. Where, as is more commonly the case, these assumptions do not hold, investment selec- tions should be made after examining the total net present values of all the feasible
Profitability index Present value Investment outlay Table 5.8
Investment opportuni- ties for Mervtech plc
Cash flows (£m) Present NPV
Project Initial value at
cost (£m) Year 1 Year 2 at 10% (£m) 10% (£m)
A 30 15
B 13 8
C 21 9
D 20 12
E 20121585 101212175 1011121017 17 3
Table 5.9
NPV vs. PI for Mervtech plc
Project Profitability index Outlay (£m) Outlay (£m) NPV (£m)
B 2.6 5 accept 5 8
D 2.5 8 accept 8 12
A 2.0 15 accept 7/15 7 7
C 1.7 12 reject – –
E 0.8 20 reject – –
60 38 27
alternative combinations of investment opportunities falling within the capital outlay constraints.
■ Multi-period capital rationing
Many business problems have similar characteristics to those exhibited in the capital rationing problem, namely:
1 Scarce resources have to be allocated between competing alternatives.
2 An overriding objective that the decision-maker is seeking to attain.
3 Constraints, in one form or another, imposed on the decision-maker.
As the number of alternatives and constraints increases, so the decision-making process becomes more complex. In such cases, mathematical programming models are particularly valuable in the evaluation of decision alternatives, for two reasons:
1 They provide descriptive representations of real problems using mathematical equations. Because they capture the critical elements and relationships existing in the real system, they provide insights about a problem without having to experi- ment directly on the actual system.
2 They provide optimal solutions – that is, the best solution for a given problem representation.
A mathematical programming approach to solving more complex capital rationing problems is provided in Appendix II to this chapter.
Self-assessment activity 5.6
What do you understand by ‘soft’ and ‘hard’ forms of capital rationing? Give two approaches available to resolve capital rationing problems.
(Answer in Appendix A at the back of the book)
We have examined a number of commonly employed investment appraisal techniques and asked the question: to what extent do they assist managers in making wealth- creating decisions? The primary methods advocated involve discounting the incre- mental cash flows resulting from the investment decision, although non-discounting techniques are useful secondary methods for evaluating capital projects.
Key points
■ The net present value (NPV) method discounts project cash flows at the firm’s required return and then sums the cash flows. The decision rule is: accept all proj- ects whose NPV is positive.
■ The internal rate of return (IRR) is that discount rate which, when applied to proj- ect cash flows, produces a zero NPV. Projects with IRRs above the required return are acceptable.
■ The profitability index (PI) is the ratio of the present value of project benefits to the present value of investment costs. The decision rule is to accept projects with a PI greater than 1.
Continued
SUMMARY
APPENDIX I