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Capital rationing: a situation in which a company has a limited amount of capital
to invest in potential projects, such that the different possible investments need to be
compared with one another in order to allocate the capital available most effectively.
Soft and hard capital rationing
- Capital rationing may occur due to internal factors (soft capital rationing) or
external factors (hard capital rationing).
- Soft capital rationing may arise for one of the following reasons.
- Management may be reluctant to issue additional share capital because
of concern that this may lead to outsiders gaining control of the business.
- Management may be unwilling to issue additional share capital if it will
lead to a dilution of earnings per share.
- Management may not want to raise additional debt because they do not
wish to be committed to large fixed interest payments.
- There may be a desire with the organization to limit investment to a
level that can be financed solely from retained earnings.
- Capital expenditure budgets may restrict spending.
- Managers may prefer … to sudden increase in size organic (internal)
growth arising from accepting several large projects especially if the
firm does not want to employ new managers to manage such projects.
Hard capital rationing may arise for one of the following reasons:
- Raising money through the stock market may not be possible if share prices are
depressed.
- Where the providers of equity or debt capital perceive the firm to be too risky
e.g highly geared
- Where the floatation costs of raising a small of capital is punitively high.
- Where interest rates in the economy are very high discouraging firms
borrowing and using only internally available funds.
Kavungya answered the question on December 15, 2021 at 07:08
- Explain how tax treatment of capital expenditure can affect investment decision.(Solved)
Explain how tax treatment of capital expenditure can affect investment decision.
Date posted: December 15, 2021. Answers (1)
- The Independent Film Company plc is a film company which purchases distribution rights on films from small independent producers, and sells the films on to...(Solved)
The Independent Film Company plc is a film company which purchases distribution rights on films from small independent producers, and sells the films on to cinema chains for national and international screening. In recent years the company has found it difficult to source sufficient films to maintain profitability. In response to the problem, the Independent Film Company has decided to invest in commissioning and producing films in its own right. In order to gain the expertise for this venture, the Independent Film Company is considering purchasing an existing
filmmaking concern, at a cost of Sh.400,000. The main difficult that is anticipated for the business is the increasing uncertainty as to the potential success/failure rate of independently produced films. Many cinema chains are adopting a policy of only buying films from large international film companies, as they believe that the market for independent films is very limited and specialist in nature. The Independent Film Company is prepared for the fact that they are likely to have more films that fail than that succeed, but believe that the proposed film
production business will nonetheless be profitable.
Using data collection from the existing distribution business and discussions with industry
experts, they have produced cost and revenue forecasts for the five years of operation of the
proposed investment. The company aims to complete the production of three films per year.
The after tax cost of capital for the company is estimated to be 14%.
Year 1 sales for the new business are uncertain, but expected to be in the range of Sh.4-10
million. Probability estimates for different forecast values are as follows:
Sales are expected to grow at an annual rate of 5%.
Anticipated costs related to the new business are as follows:
Additional Information
(i) No capital allowances are available.
(ii) Tax is payable one year in arrears, at a rate of 33% and full use can be made of tax
refunds as they fall due.
(iii) Staff wages (technical and non-production staff) and actors‟ salaries, are
expected to rise by 10% per annum.
(iv) Studio hire costs will be subject to an increase of 30% in Year 3.
(v) Screenplay costs per film are expected to rise by 15% per annum due to a shortage of
skilled writers.
(vi) The new business will occupy office accommodation which has to date been let out for
an annual rent of Sh.20,000. Demand for such accommodation is buoyant and the
company anticipates in finding future tenants at the same annual rent.
(vii) A market research survey into the potential for the film production business cost Sh.25,000.
Required:
Using DCF analysis, calculate the expected Net Present Value of the proposed investment.
(Workings should be rounded to the nearest Sh.‟000‟)
Date posted: December 15, 2021. Answers (1)
- A working capital policy of any business is critical to its viability as a going concern. The board of directors would ignore the information of...(Solved)
A working capital policy of any business is critical to its viability as a going concern. The board of directors would ignore the information of such a policy to its great disadvantage.
The finance director of Watu Limited is formulating the company's capital policy for next year.
Sales have been protected at Sh.240 million next year. Three alternative policies are under
consideration as follows:
1. Maintain current asset level at 40 per cent of projected sales.
2. Maintain current asset level at 50 per cent of projected sales.
3. Maintain current asset level at 60 percent of projected sales.
Required:
(a) Discuss the expected impact of policies (1) and (3).
(b) The fixed assets of Watu Limited are Sh.100 million and the company wishes to
maintain a 60 percent debt ratio. The cost of capital for Watu Limited is currently 12
percent on both short-term and long-term debt. This is the rate which the firm also
applies on its permanent capital structure. The company earns 15 percent on sales.
What is the expected return on equity under each of the three policies above?
(c) Are earnings and level of sales independent of current asset policy in real life? Explain.
(d) What is meant by “maturity matching”, in finance?
Date posted: December 15, 2021. Answers (1)
- Can market forces be able to eliminate insider trading? Explain.(Solved)
Can market forces be able to eliminate insider trading? Explain.
Date posted: December 15, 2021. Answers (1)
- One of the objectives of the Capital Markets Authority is “the protection of investor interests;” [Capital Markets Authority Act, Cap.485A, Section 11, (1) (c)].
Several statements...(Solved)
One of the objectives of the Capital Markets Authority is “the protection of investor interests;” [Capital Markets Authority Act, Cap.485A, Section 11, (1) (c)].
Several statements have appeared in the papers to suggest that some instances of share price manipulation have been observed in Kenya.
Required:
Specify those measures which the Capital Markets Authority has taken and publicized in order to protect the investor.
Date posted: December 15, 2021. Answers (1)
- Explain the term 'Invoice discounting' and the merits and demerits of its use as a way of improving cash flow.(Solved)
Explain the term 'Invoice discounting' and the merits and demerits of its use as a way of improving cash flow.
Date posted: December 15, 2021. Answers (1)
- Nyumbani Security Ltd. is a wholesaler of household security fittings. Over the last 12 months the company has encountered increasing problems with late payment by...(Solved)
Nyumbani Security Ltd. is a wholesaler of household security fittings. Over the last 12 months the company has encountered increasing problems with late payment by debtors. The last 12 months of credit sales of Sh.67.5 million show an increase of 10% over the previous year's sales, but the company's overdraft on which it is charged 20% per annum has also increased by Sh.1.8 million over the previous year.
The company wishes to reduce its working capital requirements by reducing the debtor collection period.
Nyumbani Security Ltd.'s accountant has extracted average debtors profile which is shown below:
As an alternative way of reducing the debtors figure, Nyumbani Security Ltd. would use a debt collection service which has quoted a price of 1% of sales receipts. It is estimated that using the service will have the effect of reducing debtor days by 20 and eliminating 50% of bad debts.
Required:
Calculate the change in working capital requirements and bad debts which would result from:
(i) The introduction of the early settlement discounts.
(ii) The use of the debt collection service.
(iii) Recommend which policy should be adopted by Nyumbani Security Ltd.
Date posted: December 15, 2021. Answers (1)
- Millenium Electronics Ltd. is a company which produces a wide range of electronic goods. It has recorded a strong and consistent growth during the last...(Solved)
Millenium Electronics Ltd. is a company which produces a wide range of electronic goods. It has recorded a strong and consistent growth during the last 10 years. The management of the company is now contemplating obtaining a stock market listing.
The company's financial statements for the last financial year are summarized below:
Required:
(a) Briefly explain why companies like Millenium Electronics Ltd. seek stock market listing.
(b) Discuss the performance and financial health of Millenium Electronics Ltd. in relation
to that of the industry as a whole.
(c) In what ways would you advise Millenium Electronics Ltd. to change its financial policy
following flotation?
Date posted: December 15, 2021. Answers (1)
- Many enterprises begin as sole proprietorships and then as they grow ad become successful, the need arises for them to convert to companies and eventually...(Solved)
Many enterprises begin as sole proprietorships and then as they grow ad become successful, the need arises for them to convert to companies and eventually go public.
Required:
(a) List and explain the advantages a company derives from going public.
(b) Highlight the factors that a firm should consider when inviting an initial public offering (IPO).
Date posted: December 15, 2021. Answers (1)
- Vitabu Ltd. is a merchandising firm. The following information relates to the capital structure of the company:
1. The current capital structure of the company which...(Solved)
Vitabu Ltd. is a merchandising firm. The following information relates to the capital structure of the company:
1. The current capital structure of the company which is considered optimal, comprises: Ordinary share capital – 50%, preference share capital – 10% and debt – 40%.
2. The firm can raise an unlimited amount of debt by selling Sh.1,000 par value, 10 year 10% debentures on which annual interest payments will be made. To sell the issue it will have to grant an average discount of 3% on the par value and meet flotation costs of Sh.20 per debenture.
3. The firm can sell 11% preference shares at the par value of Sh.100. However, the issue and selling costs are expected to amount to Sh.4 per share. An unlimited amount of preference share capital can be raised under these terms.
4. The firm's ordinary shares are currently selling at Sh.80 per share. The company expects to pay an ordinary dividend of Sh.6 per share in the coming year.
Ordinary dividends have been growing at an annual rate of 6% and this growth rate is expected to be maintained into the foreseeable future. The firm can sell unlimited amounts of new ordinary shares but this will require an under pricing of Sh.4 per share in addition to flotation costs of Sh.3 per share.
5. The firm expects to have Sh.225,000 of retained earnings available in the coming year. If the retained earnings are exhausted, new ordinary shares will have to be issued as the form of equity financing.
The company is in the 30% corporation tax bracket.
Required:
(a) The cost of each component of financing.
(b) The level of total financing at which a break in the marginal cost of capital (M.C.C)
curve occurs.
(b) The weighted average cost of capital (W.A.C.C):
(i) Before exhausting retained earnings.
(ii) After exhausting retained earnings.
Date posted: December 15, 2021. Answers (1)
- Munyu Ltd. currently has a centralized billing system. All payments are made by customers to a central billing location. It requires an average of eight...(Solved)
Munyu Ltd. currently has a centralized billing system. All payments are made by customers to a central billing location. It requires an average of eight days for customers mailed payments to reach the central location. An additional three days are required to process payments before a deposit can be made into the bank account. The firm has a daily average collection of sh.10,000,000. Recently the bank has investigated the possibility of initiating a lockbox system. It is estimated that if the system is introduced customers mail payments will reach the receipt location five days sooner than is the case now. Furthermore, the processing time of the payments could be reduced to one day.
Required:
(i) The reduction in cash balances in transit to the bank brought about by the lockbox system.
(ii) The opportunity cost of the present system assuming a 5 per cent per annum return on deposits at the bank.
(iii) In light of your answer to part (ii) above, should the lockbox system be introduced, if it will cost Shs. 4,000,000?
Date posted: December 15, 2021. Answers (1)
- Write notes on the following cash management models:
(i) The Baumol model.
(ii) The Miller – Orr model.(Solved)
Write notes on the following cash management models:
(i) The Baumol model.
(ii) The Miller – Orr model.
Date posted: December 15, 2021. Answers (1)
- State and explain the methods of obtaining a listing on the stock exchange.(Solved)
State and explain the methods of obtaining a listing on the stock exchange.
Date posted: December 15, 2021. Answers (1)
- Is the stock exchange more of a primary market or a secondary market? Explain.(Solved)
Is the stock exchange more of a primary market or a secondary market? Explain.
Date posted: December 15, 2021. Answers (1)
- What is a primary market?(Solved)
What is a primary market?
Date posted: December 15, 2021. Answers (1)
- Insectkill Ltd. is considering whether to establish a new subsidiary in Uganda. The cost of the fixed assets would be Sh.10,000,000 in total, with Sh.7,500,000...(Solved)
Insectkill Ltd. is considering whether to establish a new subsidiary in Uganda. The cost of the fixed assets would be Sh.10,000,000 in total, with Sh.7,500,000 payable at once and the remainder payable after one year. A further investment of Sh.3,000,000 in working capital would be required immediately.
The management of Insectkill Ltd. expect all their investments to be financially justifiable within a four year planning horizon. The net disposal value of fixed assets after four years is expected to be zero.
The operation would incur fixed costs amounting to Sh.5,200,000 a year in the first year, including depreciation of Sh.2,000,000. These costs, excluding depreciation are expected to increase by 5% each year because of inflation. The operation would involve the manufacture and sale of a standard unit, with a unit selling price of Sh.12 and variable cost of sh.6 in the first year and expected annual increase because of inflation of 4% and 7% respectively. Annual sales are expected to be 1,250,000 units.
The company's cost of capital is 14%.
Required:
(a) Fixed costs for the four years.
(b) Total contribution for each of the four years.
(c) (i) Net Present Value of the project
(ii) Is the project viable?
Date posted: December 15, 2021. Answers (1)
- Mary Atieno owns a chain of seven clothes shops in Kisumu town. Takings at each shop are remitted once a week on Thursday afternoon to...(Solved)
Mary Atieno owns a chain of seven clothes shops in Kisumu town. Takings at each shop are remitted once a week on Thursday afternoon to the head office and are then banked at the start of business on Friday morning. As business is expanding, Mary Atieno has hired a finance assistant to help her. The finance assistant gave the following advice: “Turnover at the seven shops totaled Shs. 1,950,000 last year at a constant daily rate but you were paying bank overdraft charges at a rate of 11% per annum. You could have reduced your overdraft costs by banking the shop takings each day except Saturdays. Saturdays takings could have been banked on Mondays.
Required:
Using numbered paragraphs, comment on the significance of this advice, stating your assumptions.
(“Note” The shops are closed on Sundays).
Date posted: December 15, 2021. Answers (1)
- Name and briefly explain five ways in which cash flow problems may arise.(Solved)
Name and briefly explain five ways in which cash flow problems may arise.
Date posted: December 15, 2021. Answers (1)
- (a) Nakuru Bottlers Ltd. is a mineral water company based in Nakuru town. The company is listed on the Stock Exchange. Due to the huge...(Solved)
(a) Nakuru Bottlers Ltd. is a mineral water company based in Nakuru town. The company is listed on the Stock Exchange. Due to the huge demand for its products, the company is in the process of expanding its bottling facilities. The board of directors is undecided as to whether to have a rights issue or a placing on the stock exchange.
Required:
(i) Explain the meaning of a rights issue and list its advantages.
(ii) Explain the meaning of a stock placing and list its advantages.
(b) Nakuru Bottlers Ltd. can achieve a profit after tax of 20% on the capital employed. At present, its capital structure is as follows:
Required:
(i) Calculate the number of shares that must be issued if the rights issue price is Sh.25, Sh.23.40, Sh.21.50, Sh.26 and Sh.27.10.
(ii) Calculate the dilution in earning per share in each case.
Date posted: December 15, 2021. Answers (1)
- Hafix Ltd. is a manufacturing company. Its projected turnover for the year 2002 is Sh.150,000,000. At present the costs as percentages of sales are as...(Solved)
Hafix Ltd. is a manufacturing company. Its projected turnover for the year 2002 is Sh.150,000,000. At present the costs as percentages of sales are as follows:
On average:
1. Debtors will take 2½ months before payment
2. Raw materials will be in stock for three months.
3. Work-in-progress will represent two months worth of half produced goods.
4. Finished goods will represent one month's production.
5. Credit will be taken as follows:
(i) Direct materials 2 months
(ii) Direct labour 1 week
(iii) Variable overheads 1 month
(iv) Fixed overheads 1 month
(v) Selling and distribution ½ month
Work-in-progress and finished goods will be valued at material, labour and variable expense cost.
Required:
Working capital requirements of Haffix Ltd. assuming the labour force will be paid for 50 working weeks in the year 2002.
Date posted: December 15, 2021. Answers (1)