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10 Capital Rationing

10 Capital Rationing

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Published by: ramkishan82 on Jan 04, 2012
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Financial Management Unit 10Sikkim Manipal University
Unit 10 Capital Rationing
 10.1 Introduction10.2 Meaning of Capital Rationing10.3 Steps involved in Capital Rationing10.4 SummaryTerminal QuestionsAnswer to SAQs and TQs
Capital budgeting decisions involve huge outlay of funds. Funds available for projects may belimited. Therefore, a firm has to prioritize the projects on the basis of availability of funds andeconomic compulsion of the firm. It is not possible for a company to take up all the projects at atime. There is the need to rank them on the basis of strategic compulsion and funds availability.Since companies will have to choose one from among many competing investment proposal theneed to develop criteria for Capital rationing cannot be ignored. The companies may have manyprofitable and viable proposals but cannot execute because of shortage of funds. Another constraint is that the firms may not be able to generate additional funds for the execution of all theprojects. When a firm imposes constraints on the total size of firm’s capital budget, it is requiresCapital Rationing. When Capital is rationed there is a need to develop a method of selecting theprojects that could be executed with the company’s resources yet give the highest possible netpresent value.
 Learning Objectives:
 After studying this unit, you should be able to understand the following.1. Explain the meaning of capital rationing.2. Explain the need for capital rationing.3. Explain the process of capital rationing.4. Explain the various approaches to capital rationing.
Financial Management Unit 10Sikkim Manipal University
10.2 Meaning of Capital Rationing:
Because of the limited financial resources, firms may have to make a choice from amongprofitable investment opportunities. Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such asituation may be due to external factors or due to the need to impose internal constraints, keepingin view of the need to exercise better financial control.
 Why Capital Rationing
 Reasons for Capital Rationing 
:Capital Rationing may be due toa. External factors b. Internal constraints imposed by management
 External Capital Rationing
: External Capital Rationing is due to the imperfections of capitalmarkets Imperfection may be caused by:-a. Deficiencies in market informationb. Rigidities that hamper the force flow of Capital between firms.When capital markets are not favourable to the company the firm cannot tap the capital market for executing new projects even though the projects have positive net present values. The followingreasons attribute to the external capital rationing:-1. Inability of the firm to procure required funds from Capital market because the firm does notcommand the required investor’s confidence.2. National and international economic factors may make the market highly volatile and instable.3. Inability of the firm to satisfy the regularity norms for issue of instruments for tapping themarket for funds.4. High Cost of issue of Securities I,e High floatation cost. Smaller firms smaller firms may haveto incur high costs of issue of securities. This discourages small firms from tapping the capitalmarkets for funds.
 Internal Capital Rationing
: Impositions of restrictions by a firm on the funds allocated for freshinvestment is called internal capital rationing. This decision may be the result of a conservativepolicy pursued by a firm. Restriction may be imposed on divisional heads on the total amountthat they can commit on new projects.Another internal restriction for Capital budgeting decision may be imposed by a firm based on theneed to generate a minimum rate of return. Under this criterion only projects capable of 
Financial Management Unit 10Sikkim Manipal University
generating the management’s expectation on the rate of return will be cleared. Generally internalcapital rationing is used by a firm as a means of financial control.
 Self Assessment Questions 1
 1. When a firm imposes constraints on the total size of its capital budget, it is known as _____________.2. Internal capital rationing is used by a firm as a ______________________.3. Rigidities that affect the free flow of capital between firms cause _________________.4. Inability of a firm to satisfy the regularity norms for issue of equity shares for tapping the marketfor funds causes __________________.
Steps involved in Capital Rationing
Steps involved in Capital Rationing are:1. Ranking of different investment proposals2. Selection of the most profitable investment proposal
 Ranking of different investment proposals
 The various investment proposals should be ranked on the basis of their profitability. Ranking isdone on the basis of NPV, Profitability index or IRR in the descending order.
 Profitability index as the basis of Capital Rationing
 The following details are available:
 Cash InflowsProject Initial Cash outlay Year 1 Year 2 Year 3
 A 1,00,000 60,000 50,000 40,000B 50,000 20,000 40,000 20,000C 50,000 20,000 30,000 30,000Cost of Capital is 15 %Computation of NPV
  Year Cash in flows PV factor at 15% PV of Cash inflows
 1 60,000 0.870 52,2002 50,000 0.756 37,8003 40,000 0.658 26,320

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