Page 202 - DMGT521_PROJECT_MANAGEMENT

Unit 11: Project Cash Flow

There are two general types of capital rationing faced by a financial manager: soft capital Notes
rationing and hard capital rationing. Soft capital rationing is the type of capital rationing we
have discussed earlier, i.e. the limit on the capital budget is adopted (or imposed) by the
management for reasons cited above. On the other hand, hard capital rationing is a situation
where the financial manager is unable to raise any capital for a project under any circumstances.
This is a very unique situation, and financial manager usually faces hard capital rationing when
the firm faces severe financial difficulties (possibly bankruptcy) or he/she is prohibited to do so
due to some pre-existing contractual agreements (such as those contained in a bond covenant).
How does a financial manager makes capital budgeting decisions facing a (soft) capital rationing?
In our earlier discussions, we know that when a financial manager faces no capital rationing,
his/her goal is to maximize the value of the firm. However, with capital rationing, the goal of
the manager is to maximize the value of the firm within the investment budget constraint. In
other words, he/she will try to invest in projects that will bring the highest overall NPV (as a
group) the budget can support.

Example: Microsoft has set an investment budget of $400,000 for the next quarter for its
Internet division. It is able to raise capital at a cost of 10% and it is considering in investing in the
following projects:

Project Cost NPV IRR
1 $100,000 $36,000 12%
2 250,000 110,000 14%
3 50,000 25,000 10%
4 150,000 120,000 13%
5 200,000 130,000 11%

Since the cost of capital is 10%, all the 5 projects are acceptable. However, Microsoft cannot
invest in all of them due to its investment budget. The 5 projects cost a total of $750,000, which
exceeds the investment budget of $400,000.

Microsoft can pick different combination of projects that are affordable (with the capital rationing).
The combination of projects 1, 2 and 3 is one possibility, and the combination of projects 1, 3 and
5 is another possibility. In this case, Microsoft needs to figure out the different combinations of
projects that it can afford, and pick the one with the highest NPV. In this particular example, the
financial manager has an easy job of determining the appropriate combination of projects that
is affordable and brings in the highest value. However, in most situations a firm faces more than
5 projects. As the number of available project increases, the number of combinations also increases.
As a result, a firm needs to use a computer to figure out what is the best combination using linear
programming.
From the above discussion, we know that a large number of available projects make capital
budgeting decision very difficult when the firm is facing capital rationing. There are other
factors that make capital budgeting decisions under capital rationing even more difficult:
(1) projects with different risk level, and (2) multiple time constraints.
1. Projects with different risk level: At this point in time, computer software has not been
developed to handle projects with different risk levels. It is possible for the managers to
factor the risk level in their computation with a small number of projects. However, when
the number increases, they need to use a computer to find the best combination, but the
computer software cannot handle different risk level.

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