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The act of placing restrictions on the amount of new
investments or projects undertaken by a company. This
is accomplished by imposing a higher cost of capital
for investment consideration.
The situation that exists if a firm has positive NPV
Projects but cannot find the necessary financing. For
example, as division managers for a large corporation, we
might identify $5 million in excellent projects, but find
that, for whatever reason, we can spend only $2 million.
Now what? Unfortunately, for reasons we will discuss,
there may be no truly satisfactory answer.
Hard Capital Rationing: It is when the capital
infusion(mixture) is limited by external sources.
Hard rationing: The situation that occurs when a
business cannot raise financing for a project under any
Economic conditions (recession).
Lack of security.
Lack of or poor track record.
Soft Capital Rationing: It is when the restriction is
imposed by the management.
Soft rationing: The situation that occurs when units
in a business are allocated a certain amount of
financing for capital budgeting.
Lack of management skills.
Focus on Key areas.
Too many projects undertaken.
Capital rationing can apply to a single period, or to
multiple periods. Single-period capital rationing
occurs when there is a shortage of funds for one period
Multi-period capital rationing is where there will be
a shortage of funds in more than one period.
It is not wrong to say that all the investments with
positive NPV should be accepted but at the same
time the ground reality prevails that the availability
of capital is limited. The calculation and method
prescribes arranging projects descending(downward)
order of their profitability based on IRR, NPV and PI
and selecting the optimal combination.
The (IRR) on a project is the rate of return at which
the projects NPV equals zero.
For the IRR, the decision rules are as follows:
If IRR > expect rate, accept the project
If IRR< expect rate, reject the project
The difference between the present value of cash
inflows and the present value of cash outflows. NPV is
used in capital budgeting to analyze the profitability of
an investment or project.
Projects with NPV > 0 increase stockholders
Projects with NPV < 0 decrease stockholders
For one year project
For more than one year project
In case of projects which are divisible (in which we
can complete some part of the project) . We use
the profitability index in order to find the optimal
Definition of 'Profitability Index'
An index that attempts to identify the relationship
between the costs and benefits of a proposed project
through the use of a ratio calculated as:
Accept a project if the profitability index is greater
than 1, stay indifferent if the profitability index is zero
and don't accept a project if the profitability index is
Profitability index is sometimes called benefit-cost
ratio too and is useful in capital rationing since it helps
in ranking projects based on their per dollar return.
Profitability Index 1000/2000=50 % 1000/4000=25%
NPV of Project. 1000 1000
Initial investment.($) 2000 4000
In case of non divisible projects we don’t have the
option of completing a part of the project. So in
this case we have to use the trial and approach
method to find out the best possible alternatives
given the limited amount of capital.