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CAPITAL RATIONING 03

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A PRESENTATION ON CAPITAL RATIONING .
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Page 1: CAPITAL RATIONING 03

A PRESENTATION ON

CAPITAL RATIONING

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Page 2: CAPITAL RATIONING 03

INTRODUCTION

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Every company maintains budget for different departments. The technique of capital budgeting is applied to select the best project giving a positive return over the time. But what happens when there are many good projects chosen by capital budgeting technique and budget for investment is limited. Of course it is understandable for any company there is hardly so much cash available so as to sufficiently invest in all projects. So what does the company do in such situations? It optimally uses the available fund for project investments. This also means that sometimes many a good project could not be selected because of limitation in the investment amount allocated. This process of deliberately restricting investments in new projects even after knowing the fact that the project can be a profitable one is called capital rationing.

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MEANING

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Capital rationing is technique which is used with capital budgeting techniques. Capital rationing technique is used when company has limited fund for investing in profitable investment proposals. In other words Capital rationing is a strategy employed by companies to make investments based on the current relevant circumstances of the company. Capital rationing refers to a situation where the firm is constrained for external, or self imposed, reasons to obtain necessary funds to invest in all investment projects with positive net present value (NPV). Under capital rationing, the management has not simply to determine the profitable investment opportunities, but it has also to decide to obtain that combination of the profitable projects which yields highest net present value (NPV) within the available funds.

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NEED FOR CAPITAL RATIONING

Capital rationing may rise due to external factors or internal constraints imposed by the management. Thus there are two types of capital rationing.

External capital rationing Internal capital rationing

External capital rationing External capital rationing mainly occurs on account of the imperfections in capital markets. Imperfections may be caused by deficiencies in market information, or by rigidities of attitude that hamper the free flow of capital. .

Internal capital rationing Internal capital rationing is caused by self imposed restrictions by the management. Various types of constraints may be imposed. For example, it may be decide not to obtain additional funds by incurring debt. This may be a part of the firm’s conservative financial policy..

Page 5: CAPITAL RATIONING 03

STEPS IN CAPITAL RATIONING

Capital Rationing Situation refers to the choice of investment proposals under financial constraints in terms of a given size of capital expenditure budget. The objective is to select the combinations of projects would be the maximization of the total NPV. The project selection under capital rationing involves two stages:

Identification of the acceptable projects.Selection of the combination of projects.

The acceptability of projects can be based either on PROFITABILITY INDEX or IRR. The method of selecting investment projects under capital rationing situation will depend upon whether the projects are indivisible or divisible. In case the project is to be accepted or rejected in its entirety, it is called an indivisible project. A divisible project on the other hand, can be accepted or rejected in part.

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SITUATIONS OF CAPITAL RATIONING

Capital Rationing decisions can be studied under the following circumstances:

Situation 1: Projects are divisible and constraint is a single period one

The following are the steps to be adopted for solving the problem under this situation:

a) Calculate the profitability index of each project.

b) Rank the projects on the basis of the profitability index. c) Choose the optimal combination of the projects.

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PROJECT INITIAL INVESTMENT NPV

A 1,00,000 20,000

B 3,00,000 35,000

C 50,000 16,000

D 2,00,000 25,000

E 1,00,000 30,000

Total fund available is rs. 3,00,000. determine the optimal combination of projects assuming that the projects are divisible.

SOLUTION

PROJECT INITIAL INVESTMENT NPV PI(3/2) RANK

(1) (2) (3) (4) (5)

A 1,00,000 20,000 0.2 3

B 3,00,000 35,000 0.117 5

C 50,000 16,000 0.32 1

D 2,00,000 25,000 0.125 4

E 1,00,000 30,000 0.3 2

Therefore , the optimal combination of projects is C,E,A and 1/4th portion of D.

Page 8: CAPITAL RATIONING 03

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SITUATION 2: Projects are indivisible and constraint is a single period one.

The following steps to be followed for solving the problem under this situation:

a) Construct a table showing the feasible combination of the project ( whose aggregate of initial outlay does not exceed the fund available for the investment.

b) Choose the combination whose aggregate NPV is maximum and consider it as the optimal project mix.

Page 9: CAPITAL RATIONING 03

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Using the same data as used in the previous illustration, determine the optimal project mix on the basis of the assumption that the projects are indivisible.

FEASIBLE COMBINATION AGGREGATE OF NPV

A,C 36,000

A,D 45,000

A,E 50,000

C,D 41,000

C,E 46,000

D,E 55,000

A,C,E 66,000

By a careful inspection of the feasible combinations constructed in the above table , we can conclude that the optimal project mix is A,C,E because the aggregate of their NVPs is maximum.

Page 10: CAPITAL RATIONING 03

ANOTHER ILLUSTRATION

Ganga ltd. has considered seven independent projects, namely A,B,C,D,E,F,G for implementation. The company has a capital budget of rs. 400 lakhs. The minimum acceptable rate of return is 7%.

RATIONING BASED ON NPVPROJECT INVESTMENT NPV @ 7%

A 100 54.73

B 100 40.47

C 200 87.01

D 200 283.01

E 200 62.23

F 50 4.76

G 50 26.08

The optimum set comprise of projects D and C. By implementing them with an investment of rs. 400 lakhs( rs.200 + rs. 200), the company would earn return whose present value is rs. 370.021 lakhs (rs 283.007 + rs. 87.014)

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RANKING BASED ON IRR

PROJECT INVESTMENT IRR(%)

A 100 13.6

B 100 15.1

C 200 22.1

D 200 20.7

E 200 12.0

F 50 11.9

G 50 16.7

Among the seven projects, project C has the highest IRR of 22.1% and hence this project can be selected first and its commitment of funds is rs. 200 lakhs. The project having next best IRR is project D (IRR = 20.7%) and its commitment of funds is also rs. 200 lakhs.

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.RANKING BASED ON PROBABILITY INDEX(PI)

PROJECT PV OF OUFLOWS PV OF INFLOWS PI

A 100 154.73 1.547

B 100 140.47 1.405

C 200 287.01 1.435

D 200 483.01 2.415

E 200 262.23 1.311

F 50 54.76 1.095

G 50 76.08 1.522

Under the profitability index ranking projects D ,A and G has scored the first three ranks with a total funds comprising of rs. 350 lakhs. Obviously projects C,B and E which are in the sequence of decreasing PI, cannot be selected because they cannot accommodated from the balance of funds i.e. rs. 50 lakhs ( rs 400 lakhs – rs 350 lakhs) available for investment. Hence project F is selected to complete the optimum set.

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CONCLUSION

As seen from the above illustration, the decision regarding choice of set of projects which best meets the corporate financial objective in a capital rationing situation depends upon the criterion used for selection. The present value of the returns to the enterprise is , in general , different for each of the combinations recommended by using different criterion. There is no guarantee that one particular criterion will always give a solution by which the present value of the returns will be more than that for the combination obtained by using other criterion. In some cases NPV may result in the best solution. In some others , IRR may give the best combination of projects. While in still others, the set of projects chosen by using PI as the criterion may help maximize the net returns to the enterprise.

Sometimes two or even all three criterion may result in the same solution.


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