INVESTMENT DECISION

UNDER CAPITAL RATIONING

INTRODUCTION
 A firm should accept all profitable capital

projects which increases the wealth of shareholders.

 If a firm may not have sufficient financial

resources, there arises a need for capital rationing.

Capital rationing
 Capital rationing arises in a situation where a

concern has more profitable projects than it can finance.

 Therefore, the firms may have to choose

among profitable projects.

MEANING-CAPITAL RATIONING
 Capital rationing means the allocation of the

limited funds ( that is available for financing the capital projects) to only some of the profitable projects in such a manner that long term returns are maximized.

MEANING-CAPITAL RATIONING
 On the other hand, Capital rationing means

Selection of only some of the profitable proposals and rejection of other profitable proposals due to limited availability of funds.

CAPITAL RATIONING
 Under capital rationing, the management has

not only to determine the profitable investment opportunities, but it should also select a combination of profitable projects which yields highest NPV within available funds.

Types of Capital rationing

There are two types 1. External capital rationing 2. Internal capital rationing


External capital rationing

 External rationing arises on account of

imperfections in capital market.  Imperfection may be due to deficiency in market information  Rigidity- affect free flow of capital  Fear of losing control

Internal capital rationing

 Internal capital rationing is caused by self-

imposed restrictions by the management.

 For ex- Conservative policy Not raising

additional debt.  Limit on investment .

STEPS INVOLVED IN CAPITAL RATIONING

TWO STEPS 1. Ranking of the different investment proposals
 2.

Selection of some of the profitable projects

 Decision Rules (No Capital Rationing):



Independent Projects:
 

IRR u k - Accept IRR < k - Reject Select the project with the highest IRR, assuming IRR u k.

Mutually Exclusive Projects:



 Multiple IRRs:


There can be as many IRRs as there are sign reversals in the cash flow stream. When multiple IRRs exist, the normal interpretation of the IRR loses its meaning.

Capital Rationing: An Example

(Firms Cost of Capital = 12%)
 Independent projects ranked according to their

IRRs: Project Project Size E $20,000 B 25,000 G 25,000 H 10,000 D 25,000 A 15,000 F 15,000 C 30,000

IRR 21.0% 19.0 18.0 17.5 16.5 14.0 11.0 10.0

 No Capital Rationing - Only projects F and C would

be rejected. The firms capital budget would be $120,000.

 Capital Rationing - Suppose the capital budget is

constrained 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 value to the firm. Also note, however, that a theoretical optimum could be reached only be evaluating all possible combinations of projects in order to determine the portfolio of projects with the highest NPV.