INDEX

10.1  Introduction 

10.2  Meaning of Capital Rationing 

10.3  Steps involved in Capital Rationing 

10.4  Summary 
Capital Rationing
Capital budgeting decisions involve huge outlay of funds. Funds available

for projects may be limited. Therefore, a firm has to prioritize the projects on

the basis of availability of funds and economic compulsion of the firm. It is

not possible for a company to take up all the projects at a time. 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 the need to develop criteria for Capital rationing cannot

be ignored. The companies may have many profitable and viable proposals

but cannot execute because of shortage of funds.

Meaning

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 a situation may
be due to external factors or due to the need
to impose internal constraints, keeping in
view of the need to exercise better financial
control.
 Why Capital Rationing

Reasons for Capital Rationing:

 External factors
 Internal constraints
 External Capital Rationing
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 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 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 management’s expectation on the rate of
return will be cleared. Generally internal capital rationing
is used by a firm as a means of financial control.
Steps involved in Capital Rationing

1. Ranking of different investment proposals

2. 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 is done on the basis of NPV,
Profitability index or IRR in the descending
order
 Profitability index as the basis of
Capital Rationing

Project Initial Cash Year 1 Year 2 Year 3

Outlay
A 1,00,000 60,000 50,000 40,000
B 50,000 20,000 40,000 20,000
C 50,000 20,000 30,000 30,000

Cost of capital 15%

Computation of NPV for project A

Year Cash in PV factor PV of Cash

flows at 15% in flows

1 60,000 0.870 52,200

2 50,000 0.756 37,800

3 40,000 0.658 26,320

Pv of cash Inflow 1,16,320 

Initial Cash Outlay 1,00,000 

NPV 16,320 
Computation of NPV for project B

Year Cash in PV factor PV of Cash

flows at 15% in flows

1 20,000 0.870 17,400 

 

2 40,000 0.756 30,240 

3 20,000 0.658 13,160 

Pv of cash Inflow 60,800 

Initial Cash Outlay 50,000   

NPV 10,800 
Computation of NPV for project C

Year Cash in PV factor PV of Cash

flows at 15% in flows

1 20,000 0.870 17,400 

 

2 30,000 0.756 22,680 

3 30,000 0.658 19,740  

Pv of cash Inflow 59,820  

Initial Cash Outlay 50,000   

NPV 9,820
Profitability Index

Profitability index = PV of Cash inflows  
  PV of Cash outflows 

Project A = 1,16,320 
  1,00,000  = 1.1632

Project B = 60,800        = 1.216 

50,000 

Project C = 59,820         = 1.1964 
50,000 
 Ranking of Projects

Project NPV Profitability Index

Absolute Rank Absolute Rank

A 16320 1 1.1632 3
B 2 1.216 1
C 10800 3 1.1964 2

9820
 Thank
You
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