Capital Rationing - Process and Why it is required

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It is a well known fact that there are endless opportunities in market in almost every niche but to encash every opportunity funds are required. So a wise man will choose the best opportunity with lowest risk and highest return in less time. To measure risk we use various statistical methods but to measure in monetary terms we use Capital Rationing 

Capital rationing technique is used when company has limited fund for investing in profitable investment proposals.

Capital Rationing in simple words refers to a situation where an organization cannot undertake all the projects which are having positive net present value because of shortage of capital. When company do capital rationing than it will select only that project which gives the company maximum profit.


Reasons behind Capital Rationing

Reason 1 : Increase in cost of capital

Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. After a limit cost of raising additional capital will increase because companies have limited assets to back secure loans.
Reason 2 : Lack of managerial abilities and skillful employees

Reason 2 : Lack of managerial abilities and skillfull employees

Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects.


Reason 3 – Lack of reliable forecasts

Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted.


Capital Rationing Process

- Calculate the PI for each project

- Rank all projects in term of their PIs, from highest to lowest

- Starting with the project having the highest PI, go down the list and select all projects having PI>1 until the capital budget is exhausted

Project
Initial investment
NPV
PI
Ranking NPV
Ranking PI
A
500,000
100,000
1.20
1. D
F
B
500,000
70,000
1.14
2. C
A
C
2,000,000
300,000
1.15
3. E
E
D
3,000,000
480,000
1.16
4. F
D
E
1,000,000
170,000
1.17
5. A
C
F
500,000
125,000
1.25
6. B
B

Capital Rationing: NPV vs. Profitability Index

  • The NPV method does not necessarily select the best combination of projects under capital rationing
  • The PI approach will select the optimal combination of projects provided that:
  • The budget constraint is for 1 period only
  • The entire budget can be consumed by accepting projects in descending order of PI.

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