Capital Rationing

By: Dr. Sachita Yadav

Investment Decision in a Project

From the foregoing discussion it may be recalled that the profitability of a project can be measured by any one of

the DCF techniques (viz. IRR, NPV and PI), particularly the two theoretically sound methods IRR and NPV.

Practically, the firm may accept all those projects which give a rate of return higher than the cost of capital or

which have positive NPV. And, in case of mutually exclusive projects, the projects having the highest NPV or

giving the highest rate of return may be accepted. In other words, a firm should accept that investment proposal

which increases maximum the firm’s value.

Rank the Projects

 In actual practice, however, every firm prepares its annual capital expenditure budget which depends

on the availability of funds with the firm or other considerations. In that case, a firm has to select not

only the profitable investments opportunities but also it has to rank the projects from the highest to

lowest priority, i.e. a cut-off point is selected.

 Naturally, the proposal which is above the cut-off point will be funded and which is below the cut-

off point will be rejected. It should be remembered that this cut-off point is determined on the basis

of the number of projects, funds available for financing capital expenditure, and the objectives of the firm.
Capital Rationing

 That is, in other words, question of Capital Rationing appears before us. It is normally applied to situations
where the supply of funds to a firm is limited in some way. It actually encompasses many different situations
ranging from that where the borrowing and lending rates faced by the firms differ to that where the funds
available for investment by the firm are strictly limited.

 In short, it rejects a situation where the firm is constrained, for external or self-imposed reasons, to obtain
necessary funds to invest in all profitable investment projects, i.e. a situation where a constraint is placed on
the total size of capital investment during a particular period. In the circumstances the firm has to select a
combination of investment proposals which provides the highest NPV, subject to the budget constraint.
 Selection Process under Capital Rationing:

Needless to mention that under capital rationing a firm cannot accept all the projects even if all of them are
profitable. In order to select or reject the projects, a comparison must be made among them.

Selection of project depends on two steps:

(i) Ranking the projects according to the Profitability Index (PI) or Net Present Value (NPV) method;

(ii) Selecting projects in descending order of profitability (until the funds are exhausted).

The projects can be ranked by any one of the DCF techniques, viz., IRR, NPV and PI. But PI method is
found to be the more suitable and reliable measure of profitability since it determines the relative
profitability; while NPV method is an absolute measure of profitability.
Funds available for capital expenditure in a year are estimated at Rs. 2,50,000 in a
firm. The profitability index (PI) with mutually exclusive investment proposals
are:

Which of the above

projects should be
accepted?
It has already been pointed out that the projects should be selected on the basis of profitability under PI
method and rank is assigned accordingly, subject to maximum utilisation of available funds showing:

From the solution, it becomes clear that

the first projects should be selected as the
optimum mix since they will completely
utilise the available funds amounting to
Rs. 2,50,000. Projects P6 and P8 are not
included in above as their PI is less than
unity (1) and, hence, are to be rejected.
The following investment proposals along with their profitability index (PI) are:
Here P1 ranks first. But it does not utilise fully the available funds. If P2 is selected alone, it will be worse
than P1. P3 and P2 cannot be selected since its total requirements become Rs. 1,00,000 (Rs. 60,000 + Rs.
40,000) which is more than the available funds, viz. Rs. 75,000. Therefore, if P3 and P4 are selected
available funds can completely be utilised.
As such, the mix (P3 and P4) will be the most profitable projects and they will maximise the present value
shown:

Thus, the total NPV of proposal 3 is highest in comparison with Proposals 1 and 2. As such,
the firm, in this case, will be able to utilise its scarce resources for optimum use.