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In terms of financing investment projects, three essential questions must be asked:

1.                  How much money is needed for capital expenditure in the forthcoming planning period?

2.                  How much money is available for investment?

3.                  How are funds to be assigned when the acceptable proposals require more money than is available?

 

The first and third questions are resolved by reference to the discounted return on the various proposals, since it will be known which are acceptable, and in which order of preference. The second question is answered by a reference to the capital budget. The level of this budget will tend to depend on the quality of the investment proposals submitted to top management. In addition, it will also tend to depend on:

§         top management's philosophy towards capital spending (e.g., is it growth - minded or cautious:)?

§         the outlook for future investment opportunities that may be unavailable if extensive current commitments are undertaken;

§         the funds provided by current operations; and

§         the feasibility of acquiring additional capital through borrowing or equity issues.

 

It is not always necessary, of course, to limit the spending on projects to internally generated funds. Theoretically, projects should be undertaken to the point where the return is just equal to the cost of financing these projects. If safety and the maintaining of, say, family control are considered to be more important
than additional profits, there may be a marked unwillingness to engage in
external financing and hence a limit will be placed on the amounts available for investment.

 

Even though the firm may wish to raise external finance for its investment programme, there are many reasons why it may be unable to do this. Examples include:

a)                 The firm's past record and its present capital structure may make it impossible or extremely costly to raise additional debt capital.

b)                 The firm's record may make it impossible to raise new equity capital because of low yields or even no yield.

c)                 Covenants in existing loan agreements may restrict future borrowing.

 

Furthermore, in the typical company, one would expect capital rationing to be largely self-imposed.

 

Each major project should be followed up to ensure that it conforms to the conditions on which it was accepted, as well as being subject to cost control procedures.