ACB III Capital Rationing

8/6/2019 ACB III Capital Rationing

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INVESTMENT

DECISION

UNDER CAPITAL RATIONING


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INTRODUCTION

A firm should accept all profitable capitalprojects which increases the wealth ofshareholders.

If a firm may not have sufficient financialresources, there arises a need for capitalrationing.


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Capital rationing

Capital rationing arises in a situation where aconcern has more profitable projects than itcan finance.

Therefore, the firms may have to chooseamong profitable projects.


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MEANING-CAPITAL RATIONING

Capital rationingmeans the allocation of thelimited funds ( that is available for financingthe capital projects) to only some of the

profitable projects in such a manner that longterm returns are maximized.


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MEANING-CAPITAL RATIONING

On the other hand, Capital rationingCapital rationingmeans Selection of only some of the profitableproposals and rejection of other profitable

proposals due to limited availability of funds.


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CAPITAL RATIONING

Under capital rationing, the management hasnot only to determine the profitableinvestment opportunities, but it should also

select a combination of profitable projectswhich yields highest NPV within availablefunds.


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Types of Capital rationing

There are two types

1. External capital rationing

2. Internal capital rationing


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External capital rationing

External rationing arises on account ofimperfections in capital market.

Imperfection may be due to deficiency in

market information

Rigidity- affect free flow of capital

Fear of losing control


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Internal capital rationing

Internal capital rationing is caused by self-imposed restrictions by the management.

For ex- Conservative policy Not raisingadditional debt.

Limit on investment .


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STEPS INVOLVED IN CAPITAL

RATIONING

TWO STEPS

1. Ranking of the different investmentproposals

2. Selection of some of the profitable projects


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Decision Rules (No Capital Rationing):

Independent Projects:

IRR u k - Accept

IRR < k - Reject Mutually Exclusive Projects:

Select the project with the highest IRR,assuming IRR u k.

Multiple IRRs:

There can be as many IRRs as there are signreversals in the cash flow stream. When multiple IRRsexist, the normal interpretation of the IRR loses itsmeaning.


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No Capital Rationing - Only projects F and C wouldbe rejected. The firms capital budget would be$120,000.

Capital Rationing - Suppose the capital budget isconstrained to be $80,000. Using the IRR criterion,only projects E, B, G, and H, would be accepted,even though projects D and A would also add valueto the firm. Also note, however, that a theoreticaloptimum could be reached only be evaluating allpossible combinations of projects in order todetermine the portfolio of projects with the highestNPV.

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ACB III Capital Rationing