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The act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration.

The situation that exists if a firm has positive NPV

Projects but cannot find the necessary financing. For example, as division managers for a large corporation, we might identify $5 million in excellent projects, but find that, for whatever reason, we can spend only $2 million. Now what? Unfortunately, for reasons we will discuss, there may be no truly satisfactory answer.

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Hard Capital Rationing: It is when the capital infusion(mixture) is limited by external sources.

Hard rationing: The situation that occurs when a business cannot raise financing for a project under any circumstances.

REASONS:

Economic conditions (recession).

Lack of security.

Lack of or poor track record.

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Soft Capital Rationing: It is when the restriction is imposed by the management.

Soft rationing: The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting.

REASONS:

Lack of management skills.

Focus on Key areas.

Too many projects undertaken.

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Capital rationing can apply to a single period, or to multiple periods. Single-period capital rationing occurs when there is a shortage of funds for one period only.

Multi-period capital rationing is where there will be a shortage of funds in more than one period.

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It is not wrong to say that all the investments with positive NPV should be accepted but at the same time the ground reality prevails that the availability of capital is limited. The calculation and method prescribes arranging projects descending(downward) order of their profitability based on IRR, NPV and PI and selecting the optimal combination.

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The (IRR) on a project is the rate of return at which the projects NPV equals zero.

For the IRR, the decision rules are as follows:If IRR > expect rate, accept the projectIf IRR< expect rate, reject the project

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The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.

Projects with NPV > 0 increase stockholders returnProjects with NPV < 0 decrease stockholders return

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For one year project

For more than one year project

In case of projects which are divisible (in which wecan complete some part of the project) . We usethe profitability index in order to find the optimalproject mix.

Definition of 'Profitability Index'An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:

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Decision Rule

Accept a project if the profitability index is greater than 1, stay indifferent if the profitability index is zero and don't accept a project if the profitability index is below 1.

Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it helps in ranking projects based on their per dollar return.

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Profitability Index 1000/2000=50 % 1000/4000=25%

NPV of Project. 1000 1000

Initial investment.($) 2000 4000

ALL 1/4

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In case of non divisible projects we don’t have the option of completing a part of the project. So in this case we have to use the trial and approach method to find out the best possible alternatives given the limited amount of capital.

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