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Graded Discussion Board

Corporate Finance (FIN622)

Dear Students!

This is to inform that Graded Discussion Board (GDB) No. 01 will be opened on June 01, 2015 for discussion and last date for posting your discussion comments will be June 03, 2015.

 

Topic/Area for Discussion

 “Capital Rationing”

 

“Capital rationing can be a hurdle in choosing an optimum level of capital investments.”Do you agree or disagree with this statement? In either case, support your answer with logical arguments.

 

(Note: Your discussion should not exceed 150 words. No calculation is required; you are supposed to provide comments only.)

Note:

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Corporate Finance (FIN622)

 “Capital Rationing”

Discussion Question

“Capital rationing can be a hurdle in choosing an optimum level of capital investments.”Do you agree or disagree with this statement? In either case, support your answer with logical arguments.

 

(Note: Your discussion should not exceed 150 words. No calculation is required; you are supposed to provide comments only.)

Investment Decisions under Capital Rationing


Firms may have to choose among profitable investment opportunities because of the limited financial resources. Discuss the methods of solving the capital budgeting problems under capital rationing. We shall show that the net present value (NPV) is the most valid section rule even under the capital rationing situations. 

A firm should accept all investment projects with positive net present value (NPV) in order to maximize the wealth of shareholders. The net present value (NPV) rule tells us to spend funds in the projects until the net present value (NPV) of the last project is zero. 

Capital rationing refers to a situation where the firm is constrained for external, or self imposed, reasons to obtain necessary funds to invest in all investment projects with positive net present value (NPV). Under capital rationing, the management has not simply to determine the profitable investment opportunities, but it has also to decide to obtain that combination of the profitable projects which yields highest net present value (NPV) within the available funds. 

Why capital rationing? 

Capital rationing may rise due to external factors or internal constraints imposed by the management. Thus there are two types of capital rationing. 

  • External capital rationing
  • Internal capital rationing


External capital rationing


External capital rationing mainly occurs on account of the imperfections in capital markets. Imperfections may be caused by deficiencies in market information, or by rigidities of attitude that hamper the free flow of capital. The net present value (NPV) rule will not work if shareholders do not have access to the capital markets. Imperfections in capital markets alone do not invalidate use of the net present value (NPV) rule. In reality, we will have very few situations where capital markets do not exist for shareholders.


Internal capital rationing


Internal capital rationing is caused by self imposed restrictions by the management. Various types of constraints may be imposed. For example, it may be decide not to obtain additional funds by incurring debt. This may be a part of the firm’s conservative financial policy.

Management may fix an arbitrary limit to the amount of funds to be invested by the divisional managers. Sometimes management may resort to capital rationing by requiring a minimum rate of return higher than the cost of capital. Whatever, may be the type of restrictions, the implication is that some of the profitable projects will have to be forgone because of the lack of funds. However, the net present value (NPV) rule will work since shareholders can borrow or lend in the capital markets.


It is quite difficult sometimes justify the internal capital rationing. But generally it is used as a means of financial controls. In a divisional set up, the divisional managers may overstate their investment requirements. One way of forcing them to carefully assess their investment opportunities and set priorities is to put upper limits to their capital expenditures. Similarly, a company may put investment limits if it finds itself incapable of coping with the strains and organizational problems of a fast growth.

Disagree with above statement as capital rationing restrict the resources to invest in those project which give optimum profit and not in every project available

What’s the Optimum Level of Working Capital?

If the working capital is too high, then your business has surplus funds that are not earning any returns, unless they are invested in short-term securities etc. If the working capital is too low, then your business faces the threat of financial difficulties and this will not send out a positive signal to the market. So how do you decide what is the right level of working capital for your business? 

A firm has to maintain an adequate level of working capital to run its operations smoothly and effectively. It should be adequate in the sense that it shall not be more than the requirements nor it shall be less than the requirements. Both the excessive as well as inadequate working capital positions are dangerous from the firm’s point view.

We know that the current liabilities are met out of the current assets. So the level of current assets shall be sufficient enough to meet the current liabilities. Excessive working capital refers to the position where when the level of current assets is much higher to meet current liabilities. The excessive capital has opportunity cost for the firm, as this excessive capital remains idle in the firm, which earns no profit for the firm. If these funds shall be invested in some profitable project, it adds the profitability of the Company.

On the other hand, inadequate working capital refers to the position where the current assets are not sufficient enough to meet the current liabilities. Such type of position may be harmful to the firm as it may interrupt the production and sales of the Company, which ultimately affects the profitability of the Company. Moreover if the liquidity position of the firm is not adequate enough to meet its current liabilities, it may affect its credibility in the market.

Therefore an enlightened management should maintain the right amount of working capital on a continuous basis. Only then the proper functioning of business operations can be ensured. The amount of the working capital shall be maintained at such level, which is adequate for it to run its business operations, neither excessive nor inadequate. This level of working capital is called as the “Optimum Working Capital”.

“Capital rationing can be a hurdle in choosing an optimum level of capital investments.”Do you agree or disagree with this statement? In either case, support your answer with logical arguments

As per my understanding ans should be as follow;

Disagree with the statement of "Capital rationing can be a hurdle in choosing an optimum level of capital investments" it also help us to find the best opportunity among combined investments..
Due to limited funds, companies cannot always invest in all projects that look profitable. They try to make the best possible use of funds available for investment projects.
Capital rationing is the process of selecting the most valuable projects to invest available funds. In this process, managers use a number of capital budgeting methods such as cash payback period method (CPPM), accounting rate of return (ARR) method, net present value (NPV) method and internal rate of return (IRR) method.

Please Discuss here about this GDB.Thanks

Our main purpose here discussion not just Solution

We are here with you hands in hands to facilitate your learning and do not appreciate the idea of copying or replicating solutions.

Dear Students Don’t wait for solution post your problems here and discuss ... after discussion a perfect solution will come in a result. So, Start it now, replies here give your comments according to your knowledge and understandings....

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