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Q5. Briefly explain the process of capital rationing. A5. Capital Rationing may be due to a. 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 information b. Rigidities that hamper the force flow of Capital between firms. Whencapital marketsarenot favourable to the company the firm cannot tap the ca pital market for executing new projects even though the projects have positive net present values. The following reasons attribute to the external capital rationing: 1. Inability of the firm to procure required funds from Capital market because the firm does not command the required investors 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 the market for funds. 4. High Cost of issue of Securities I,e High floatation cost. Smaller firms smaller firms may have to incur high costs of issue of securities. This discourages small firms from tapping the capital markets for funds. Internal Capital Rationing: Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing. This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects. Another internal restriction for Capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the managements expectation on the rate of return will be cleared. Generally internal capital rationing is used by a firm as a means of financial control.