Capital Rationing: Percentage Standards in Capital Expenditure Evaluation, Study notes of Finance

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WHOLLY SET UP AND PRINTED IN AUSTI~ALlA BY WATSON FERGUSON AND COMPANY, BRISBANE, QUEENSLAND 1965

REGISTERED IN AUSTRALIA FOR TRANSMISSION BY POST AS A BOOK

CONTENTS

I. INTRODUCTION

II. THEORETICAL CONSIDERATIONS

(a) Capital Investment Theory and Performance Standards (b) Capital Rationing and Performance Standards ..

III. EMPIRICAL EVIDENCE

(a) Capital Rationing in Practice (b) Performance Standards in Practice (c) Performance Standards Under Capital Rationing

IV. CONCLUSIONS

Page 85

86 90

97 100 108

113

86 G. G. MEREDITH

Solomon,3 and Bierman and Smidt,4 plus numerous papers presente~ in current professional and academic journals. Empirical evidence has been obtamed .from. a survey in 1964 of 285 Australian public companies using rate of return tec1?mques ~n capital investment analyses. All these companies had. previously: shown an mterest m capital investment analyses and had co-ope\ated m an e~rber research survey. 5 Analytical data were supplied by 215 compames-representmg 75 .. 4 per cent of ~he sample-covering rate of return performance. standards and e':Id~nce o~ ~apItal rationing. The questionnaire used in this survey IS presented OpposIte m ExhIbIt 1. The purpose of this paper is to demonstrate that: (a) Traditional capital investmeI?t t~eo~y dealin~ with p~rforItl;ance standards must be modified when capital ratIOmng IS taken mto consIderatIOn. (b) A significant percentage of Australian ,Public comp~nies oper~te capital budgets under conditions of external or self-Imposed capItal ratIOnmg, and therefore cannot accept as performance standards the theoretical ideal.

II. THEORETICAL CONSIDERATIONS

(a) Capital investment theory and performance standards

A capital investment may be defined as an outlay at one particular point of time, made in anticipation of future benefits. The money outlaid may be for shares in a firm, plant or equipment, advertising, research, etc. The future benefits may be in the form of cash or cash equivalents; they may be known with certainty or be relatively uncertain in amount; or they may represent equal annual benefits for a particular period or irregular fluctuating benefits for an indefinite period. It is traditional to examine the theory of capital investment on the assumption that each firm determines its investment policy in such a way as to maximize profits. In terms of price theory this is usually demonstrated by suggesting that any firm would choose to balance output of finished units with input of factors of production or resources in such a way as to equate the marginal costs and marginal revenues involved. Thus the firm would continue to purchase input and increase output as long as the additional revenue to be received exceeded the additional costs involved. This basic theory can be adapted to analyze the behaviour of a firm wishing to determine its optimum assets structure and method of financing these assets. Thus it is possible to describe a theory of capital investment for a firm which will determine the optimum level of investment and the optimum level of finance. In exactly the same way as for price theory, the emphasis is placed on marginal investment for the firm under consideration. Our theoretical firm will therefore continue to invest funds in additional capital projects until the return, or yield, or profit from the last invest- ment made exactly equals the additional cost of the finance raised to make the investment. The cost of finance raised for capital investment is usually measured in terms of percentage rates. Funds available for capital investment represent retained earnings (an internal supply offunds), shareholders' or owners' equity, or funds made available by such lending organizations as banks, insurance companies, etc. Each fund has a cost. The cost of shareholders' or owners' equity could be regarded as the dividend percentage, or dividend yield, or the firm's earning rate. The cost of loan funds represents the interest rate applicable. The cost of internal funds is usually regarded as an opportunity cost, that is, a percentage rate represented by the best alternative

"Ezra Solomon, The Theory of Financial Management (New York: Columbia University Press, 1964). 4H. Bierman, and S. Smidt, The Capital Budgeting Decision (New York: Macmillan, 1960). GFor a report of this survey see G. G. Meredith, Administrative Control of Capital Expenditure: A Survey of Australian Public Companies ("University of Queensland Papers, Department of Account- ancy", Vol. I, No.2 CSt. Lucia: University of Queensland Press, 1964]).

Classification.

CAPITAL RATIONING AND INVESTMENT PERFORMANCE STANDARDS 87

EXHIBIT I

UNIVERSITY OF QUEENSLAND

Department of Accountancy

CAPITAL EXPENDITURE PROCEDURES: A Survey of Australian Public

Companies.

Company No.

Use a tick mark (V) to indicate the appropriate alternative. Supply details where requested.

1. RATE OF RETURN STANDARDS:

(a) Does your company set a predetermined minimum rate of return percentage standard for proposal acceptance?

1. Yes. ( )
2. No. ( )

(b) What percentage rate represents the current standard? Give details of any variation of the standard for different types of proposals (e.g. replacement proposals: 10 per cent; expansion proposals: 15 per cent). ... , per cent ................................................................................. .. per cent .................................................................................. per cent ................................................................................. per cent ............................................................................... per cent

(c) Briefly, how are the above standards set? (e.g. before or after tax; before or after interest payments, etc.)

2. CAPITAL RATIONING:

(a) In anyone capital budget period, has the supply of funds for capital pro- posals been sufficient to finance all the acceptable (profitable) proposals sub- mitted for consideration?

1. Always sufficient funds available for proposals. ( )
2. Occasionally capital funds NOT sufficient for proposals. ( )
3. Never sufficient funds for all proposals submitted. ()

(b) Has management ever ruled that total funds allocated to capital projects be limited to a predetermined amount?

1. Regularly. ()
2. Occasionally. ( )
3. Never. () Thank you for your co-operation in this research.

CAPITAL RATIONING AND INVESTMENT PERFORMANCE STANDARDS

EXHIBIT III

DEMAND CURVE FOR CAPITAL

89

%

30

25

c 20 J ~

~ 15

" [ .lj 10

Marginal Efficiency of Capital

L--CCI0,----:2:":0----::3::"0---4';;0::----;5:;::0---';:60;;----:7;;;0:----;;S;;"0----;9;;;0----u 100 Cumulative Investment (COOO's)

EXHIBIT IV

%

30

25

20

15

Marginal Cost of Capital

Marginal Efficiency of Capital

10f-~------------'

ACCEPT REJECT 10 20 30 40 50 60 70 so 90 100 Cumulative Investment (£'OOO's)

90 G.^ G.^ MEREDITH

Theory places emphasis on the marginal cost of funds employed. The marginal cost of funds eventually determines the "cut-off" poi~t for marginal ,investments. Therefore, in theory, it is assumed that m~nagement wIll attempt ~o ra~se funds for each marginal investment at the low~s~ poss~ble cost. Event.ually a pomt wIll be reached where the marginal return on addItional mvestments wIll be so low that even the lowest-cost funds would cost more than the return from the investment. Theory therefore assumes that management has at its disposal an unlimited supply of funds (at an in~reasing^ cost) and an unlimited demand for funds (in the .form^ of^ capital projects). In practice the latter m~y be t~e .but the former may certamly not be true. Where there is any form of capItal ratIOnmg, the theory presented above must be adjusted to take this into consideration and the cut-off point or accepted performance standard must be similarly adjusted.

(b) Capital rationing and performance standards

Capital rationing may be defined as any situation in which a firm cannot or does not wish to raise funds for capital investment beyond a certain limit. This limitation of funds may be enforced by management either by making a fixed total available for the capital budget, or, while allowing the total amount available to fluctuate to a certain extent, by applying very high cut-off rates as minimum desirable rates of return. In both cases the technique results in sponsored proposals competing for limited funds. In both cases some "profitable" projects will be ignored; that is, some projects may promise a return greater than the cost of funds involved, and yet be rejected through a general restriction on investment. A number of factors may force a firm to accept a policy of capital rationing. Low profitability may force a firm to curtail future capital investment because past profitability may have had the effect of increasing out of all proportion the cost of external funds available. A firm operating at a loss may be forced to rely on equity (high cost) funds for capital investments, whereas, if the firm had been operating at a profit, external debt funds might have been available-at a significantly lower cost. Thus it may pay management to delay desirable capital investment until a present profitability situation has corrected itself. Extreme doubts as to the future certainty of operations may result in a capital rationing situation. All capital budgeting is carried out under conditions of some degree of uncertainty; however, management at anyone time may consider the future to be so uncertain that capital projects readily acceptable under normal circumstances are perhaps better curtailed until future prospects improve. Funds from external sources may not be readily available if lenders believe the future is too uncertain to risk supplying unlimited quantities of funds for capital investments. Government regulations could represent an external influence causing capital rationing within the firm. Nationalized industries of semi-governmental bodies may be restricted from time to time by government regulations or government policies, and the policies of the government-controlled banking system may also cause internal capital rationing among individual firms. In spite of the influence of external factors in the capital rationing policies of individual firms, it is most likely that capital rationing in the majority of cases is self-imposed. Top management quite often is not prepared to borrow to the limit. Experienced management would probably consider that a certain reserve of borrowing power should be retained for emergencies in anyone budget period. Possibly for this reason, many firms will restrict funds available for capital investment to a total represented by annual depreciation plus a fixed proportion of expected future profits. This will leave the company or firm in a position to approach the external market if any future emergencies arise. Management is generally not prepared to borrow to the limit of its capacity or the capacity of the firm, because such borrowing may lead to certain restrictions on operations, imposed by lenders. Many reasons, some of which have been given above, could be put forward to

92 G. G. MEREDITH

EXHIBIT VI

DEMAND SCHEDULE UNDER CAPITAL RATIONING

Rate of Return Outlay^ Cumulative Outlay £ £

30 per cent 20,000^ 20, 25 per cent 10,000^ 30,000^ ACCEPT 20 per cent 30,000^ 60,000J

f Cut-off

I.. point

15 per cent 40,000^ 100,000^ ~REJECT

While these rules may appear straightforward, their application to practical situations will inevitably cause difficulties because rate of return analyses may not indicate the selection of the most profitable projects under specific conditions when competing projects have differing initial outlays, differing useful lives, varying rein- vestment rates, or are to any degree mutually exclusive. 6 For these reasons, it has been suggested by many that the rate of return method of analysis should be modified, and the so-called present value method' or the present value index method of analysis 8 used to select the most profitable projects. When these methods are used, a predeter- mined rate of discount is applied to the projects' cash flows so that the projects with the greatest net present values (or present value indexes) may be selected for the current budget period. The purpose of the analysis is to select those projects which increase the total present value of future benefits to anyone budget period. The use of these present value methods assumes that the discount rate is predetermined, and therefore some consideration must be given to the selection of a discount rate which will result in the most beneficial projects being accepted. The selection of an appropriate discount rate is most important, because the discount rate used in project analysis will determine the projects accepted from among those competing for funds available. This results from the nature of compound interest tables, since the present value factors from these tables decrease as interest rates and future time periods increase. Exhibit VII represents an extract from present value tables and shows that the present value factor for 5 per cent one year hence is greater than the present value factor for 25 per cent one year hence; and the factor for 5 per cent one year hence is greater than the factor for 5 per cent five years hence, etc. EXHIBIT VII PRESENT VALUE TABLES FOR A SINGLE PAYMENT OF £

YEARS HENCE

INTEREST RATE

5 Per Cent 10 Per Cent 15 Per Cent 20 Per Cent I 25 Per Cent I 30 Per Cent -----1------------------------1-----1---·--- 1 2 3 4 5

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

"For a detailed discussion on these problems see: J. H. Lorie, and L. J. Savage, "Three Problems in Rationing Capital", Journal of Business, University of Chicago Press, October, 1955, included in Ezra Solomon (ed.), The Management of Corporate Capital (New York: Free Press of Glencoe, 1961), page 56. 'J. H. McArthur, "Measuring Rate of Return on Capital Investments", Canadian Chartered Accountant, October, 1960, page 317. "G. N. Bowles, "Discounted Cash Flow-Interpretation of Results", The Australian Accountant, XXXII, No. 11 (November, 1962), 614.

CAPITAL RATIONING AND INVESTMENT PERFORMANCE STANDARDS 93

Therefore if the present value method of analysis is applied in the analysis of proposals, the use of a low rate of discount as opposed to a high rate will produce a bias in favour of proposal acceptance, because the higher discount factors associated with this low percentage rate will result in higher present value of future cash flows. This could quite possibly result in the acceptance of proposals unfavourable for the firm. Under conditions of capital rationing this situation must be avoided. Consider the proposal set out in Exhibit VIII, which has been submitted to management for consideration in the current budget period.

EXHIBIT VIII

Years Hence

o 1 2 3 4 5

Cash Flow £ (1,000) 100 120 200 500 280

When these future cash flows are discounted at, for example,S per cent, as in Exhibit IX, the proposal appears to be acceptable, as the present value of future benefits (£1,007) is greater than the required outlay (£1,000).

EXHIBIT IX

YEAR

1 2 3 4 5

• PRESENT VALUE AT 5 PER CENT CASH FLow ---~~------~---- Factor Value £ £

100 .9524 95 120 .9070 109 200 .8638 173 500 .8227 (^411) 280 .7835^219

£1,200 £1,

Ifmanagement discounts the cash flows at 15 per cent, as in Exhibit X, the opposite result is found. The proposal no longer appears to be acceptable at this high cut-off rate.

EXHIBIT X

YEAR CASH FLOW PRESENT VALUE AT 15 PER CENT ~-~--------~----- Factor I

Value £ £

1 100 .8696 87 2 120 .7561 (^91) 3 200 .6575 132 4 500 .5718^286 5 280 .4972^139

£1, I

£

CAPITAL RATIONING AND INVESTMENT PERFORMANCE STANDARDS 95

problems associated with the selection of an appropriate rate under conditions of capital rationing. In establishing an appropriate discount rate or standard of performance it is quite often suggested that a company should use a basic minimum rate as a cut-off point, and under conditions of capital rationing this minimum rate should represent the future average cost of capital to the firm. In theory each firm should ensure that no investments are made which cannot earn enough to pay the cost of capital in any one particular period. The emphasis is placed on average future cost of capital rather than on the marginal cost of capital which, in theory, is appropriate when capital rationing does not apply. However, under conditions of capital rationing, it is probably logical for a firm to use fluctuating discount rates from one period to the next, these fluctuating rates being determined by the intersection of the forecasted demand and supply curve for capital. This allows management to manipulate or regulate the minimum rate of return desired depending on the supply of funds available and the future expectations of returns from investments. It could thus be assumed that a company would raise its minimum return under prosperous business conditions and possibly lower the return in the reverse situation. However, in both cases the company's cost of capital (the marginal cost of capital) would act as a base minimum cut-off rate. Exhibit XIII represents the situation of a firm committed to a policy of capital rationing and determined to limit capital investments to internally generated funds only.

EXHIBIT XIII

% Sa Sb 25 I \ I \ (^) , ,I \ (^) I 20

20% (^) \

M M, 1,

I \

I ^ ,

I ,

IS II , I

10

Sc

I I -__ I I

• • • • -l5Yo
    • • ---- Db

D.

10 20 30 40 50 60 70 80 Cumulative Investment (COOO's)

If the minimum cut-off rate is set at 20 per cent, and the demand curve for capital is Da, the supply curve will be represented by Sa, cutting the demand curve at point M, i.e. at the 20 per cent mark, indicating that £20,000 will be allocated for investment. If, due to improved business conditions, the demand curve for capital moved to the right to a position Db, it would be reasonable to expect the supply curve in the nature of retained earnings also to move to the right from the position Sa to the new position Sb, cutting the demand curve at point MI, still at the 20 per cent line. This representation in Exhibit XIII may give the impression that the cut-off rate would never vary under any conditions. However, this is not likely to be true,

96 G. G. MEREDITH

but it can be said that changing demand and changing supply as indicated in Exhibit XIII tends to reduce the fluctuations of this cut-off rate. If the supply of retained earnings was such as to move the supply curve to Sc, the cut-off point would become 15 per cent. If it is now assumed that the firm under capital rationing would be prepared to supplement retained earnings from external capital sources, the theoretical representa- tion of this situation appears in Exhibit XIV. The supply curves change from vertical to horizontal lines since external capital sources are accepted.

EXHIBIT XIV

%

25

5

IS Sb

Sa

80

-----Db

70

P, 60

Da

H,

SO

-------------~~----~

H I I I I I I

I I P r^ P, (^1020 30 )

I I I I I I I I I

10 - - - - -1.- _ I I I I I I I I

I PI

20 - - - -

Cumulative Investment (COOO's)

The original supply curve for the firm is Sa, represented by the cost of capital which rises with increasing investment. The original demand curve for capital is Da. In the situation depicted in Exhibit XIV, where retained earnings are represented by the line OP, apparently the use of the retained earnings can only be justified for projects offering a marginal return of some 16 per cent. Therefore ideally the firms should pay out as dividends an amount equal to P-Pl and return the retained earnings to an amount equal to OPI which satisfies the demand for capital at the cut-off rate of 20 per cent, in this case the cost of capital. If general business conditions improved so as to increase the demand for capital and shift the demand curve to the right to the position Db and at the same time lowered the company's cost of capital from 20 per cent to 10 per cent, then, if OP2 represents the available funds from retained earnings, the company should be prepared to make up the additional capital required to satisfy demand at the point Ml by borrowing from external sources the amount P 3-'P 2' In this case the cost of capital has set the basic minimum rate which will be acceptable for many projects. While the theory presented in Exhibits XIII and XIV may appear attractive for establishing rules concerning decision making, the theory does not solve the problem of determining a minimum discount rate to be used in an analysis in such a way as to ensure that the most acceptable projects will be carried out by the firm. The above theory suggests that the cost of capital percentage should be used at the appropriate discount when the present value method of analysis is applied. If it is accepted that companies can calculate with some accuracy the cost of capital, it still does not follow that the cost of capital may be the correct rate to use in such analysis. The cost of

98 G. G. MEREDITH

establish with some degree of accuracy the extent to which capital rationing was practised by Australian companies. One question on the survey sheet specifically referred to rationing (see Exhibit I). Companies were asked:

In anyone capital budget period, has the supply of funds for capital proposals been sufficient to finance all the acceptable (profitable) proposals submitted for consideration?

1. Always sufficient funds available for proposals. ( )
2. Occasionally capital funds NOT sufficient for proposals. ( )
3. Never sufficient funds for all proposals submitted. ( )

One hundred and ninety-one companies recorded an answer to this question.

Number of companies answering Part 1 of question: 74 = 38.8 per cent Number of companies answering Part 2 of question: 91 = 47.6 per cent Number of companies answering Part 3 of question: 26 =~ 13.6 per cent

191 = 100.

It is not surprising that the majority of the replies (47.6 per cent) referred to Part 2 of the question. It would probably be expected that the majority of companies would occasionally follow a policy of capital rationing depending upon the prevailing and expected future economic climate within their particular industry. The question was specifically worded to discourage replies being given to Parts 1 and 3 unless the companies concerned were sure that these conditions consistently prevailed. In Part I of the question the words "always sufficient funds", and in Part 3 of the question "never sufficient funds", were meant to represent two extreme conditions of operations. Taking into consideration the usual errors of recording which are associated with a mail survey, it could be concluded that some 38.8 per cent of Australian companies have not found it necessary in the past to follow a policy of capital rationing, while 61.2 per cent have at some time found it necessary to ration funds for capital invest- ments. For the majority of this latter group (47.6 per cent), the need to ration capital varies from period to period. However, the fact that these companies do occasionally find it necessary to ration capital is significant for purposes of this study. Comparative data from similar studies into the question of capital rationing are difficult to find; however a recent United Kingdom surveyll covered a random sample of 300 public companies from the Stock Exchange Yearbook and analyzed replies from 120 of these companies. Sixty-nine companies reported that the amount of capital available for investment in anyone budget period was a limited amount, predetermined periodically by boards of directors or parent companies. Eight com- panies in this group qualified their reply to some extent; however some 50 per cent of the companies indicated that capital rationing was important as far as their budgeting policies were concerned. The report of the above United Kingdom survey tends to support the results obtained in the Australian survey, and it therefore seems reasonable to conclude that in practice the policy of capital rationing by companies is sufficiently widespread to warrant an investigation into its effect on the determination of performance standards. Before examining the performance standards reported by Australian companies, it is of interest to analyze the effect of capital rationing on companies within differing industries and on companies of differing sizes.

"Reported in: G. H. Lawson, "Criteria to be Observed in Judging a Capital Project", The Accountants' Journal, LVI, No. 672 (May, 1964),222-26, and LVI, No. 673 (June, 1964),267-76.

CAPITAL RATIONING AND INVESTMENT PERFORMANCE STANDARDS 99

Company industry Those companies supplying data were analyzed into five industry groups: predominantly manufacturing, wholesale/distribution, retail trading, finance, and one general group to cover all other industries. The replies of each industry group to the question concerning capital rationing are presented in Exhibit XV.

EXHIBIT XV

EVIDENCE OF CAPITAL RATIONING·-ANALYZED BY COMPANY INDUSTRY

INDUSTRY REPLY Manufact- Wholesale/ uring Distribution

Retail Finance (^) Other I Total

74

91

18

22

43.7 4 100.

6.3 - - 110 20.0 26 13. 100.0 4 100.0 50 100.0 191 100.

7

8

1

16

Total 90 100.0 (^31) 100.

• No~aPita~ NO']_ % - N_o. I__%I_N_O.....-- No-.-~~-- -No.--~-~-·· -N-o-:...-I-_-%-

rationing 35 38.9 10 Occasional rationing 45 50.0 16 Consistent rationing 10 11.1 5

While it is evident that the sample in some of the industry classifications is small, it is significant to note from the results in Exhibit XV that finance companies reported no policies of capital rationing, retail trading companies reported less capital rationing than the average, wholesale/distribution companies reported more capital rationing than the average, while manufacturing companies closely followed the average for all industries.

Company size Companies were analyzed in terms of company size as indicated by paid-up capital. Paid-up capital was selected as a representative of relative company size because this figure was readily available for all the companies included in the survey, and it was considered that a close correlation existed between paid-up capital of Australian public companies and the assets employed by those companies. Therefore if assets could be used as an indicator of company size it was considered that paid-up capital could also be used as an indicator of size. Companies were classified into six groups: those with paid-up capital of less than £100,000; companies with paid-up capital between £100,000 and £200,000; companies with paid-up capital between £200,000 and £500,000; companies with paid-up capital between £500,000 and £ million; companies with paid-up capital from £1 million to £5 million; and the final classification was for companies with paid-up capital of over £5 million. An analysis of the extent of capital rationing by company size is presented in Exhibit XVI. Several significant points are evident from the data included in Exhibit XVI. Firstly, the smallest and the largest companies are apparently only occasionally concerned with a policy of capital rationing. This is probably due to the fact that the smallest of companies would be those with the smallest volume of capital expenditure while the largest companies have greater borrowing power than the smaller companies. At the other extreme, companies in the size classification £200,000 to £500,000 have reported a high dependence on capital rationing (69.8 per cent-20.7 per cent con- sistent rationing). As a general conclusion, it is evident that capital rationing is an important factor in the capital budgeting process of Australian public companies. The exact significance