Capital rationing - Meaning, Types and Problems of Project Selection under capital rationing

Capital rationing - Meaning, Types and Problems of Project Selection under capital rationing

1. Presented by : Manasa H J 1 st M.Com Capital rationing: Meaning, types and problems of project selection under capital rationing Under the guidance of Sundar B. N. Asst. Prof. & Course Co-ordinator GFGCW, PG Studies in Commerce Holenarasipura

2. CONTENTS CAPITAL RATIONING Introduction Meaning Types Selection of projects Conclusion Reference

3. Introduction Capital rationing is defined as the process of placing a limit on the extent of new projects or investments that a company decides to undertake. This is made possible by placing a much higher cost of capital for the consideration of the investments or by placing a ceiling on a particular proportion of a budget. A company might intend to implement capital rationing in scenarios where the past revenues generated through investments were not up to the mark .

4. MEANING: - Rationing is the process of allocating scarce resources on the basis of priority based on certain criterion. It is a situation when the company cannot undertake all investment projects with positive NPV .

5. CONSIDER THE FOLLOWING SITUATION No problem if the company has sufficient funds Suppose, the firm has only Rs. 200 lakhs ; the firm cannot invest in or undertake all projects which have positive NPV or IRR above the cost of capital In this case the firm has to reject project “B”-a profitable investment project due to lack or insufficiency of capital Further, cannot maximize the wealth Such a situation warrants capital rationing

6. Capital Rationing Capital Rationing Single Period capital Rationing Soft and Hard Rationing Multi Period capital Rationing Divisible projects Non-divisible projects Profitability Index(PI) Trial and Error

7. HARD CAPITAL RATIONING SOFT CAPITAL RATIONING Hard capital rationing : It is when the capital infusion is limited by external sources. The situation that occurs when a business cannot raise financing for a project under any circumstances. Soft capital rationing : It is when the restriction is imposed by the management. The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting. REASONS Economic conditions Lack of security. Lack of or poor track record . Start-up firms Poor Management /Track record REASONS Lack of management skills. Focus on key areas. Too many projects undertaken. Promoter ’ s Decision Future Scenarios TYPES OF CAPITAL RATIONING

8. Single and Multi period capital Rationing 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.

9. SELECTION OF POJECT Under capital rationing management has to determine not only profitable investment opportunities but also decide to obtain that combination of investment projects which yields highest NPV within the available funds by ranking them according to their relative probabilities . May face two situations :- A. Projects are divisible B. Projects are indivisible

10. A. When projects are divisible Steps Calculate profitability Index of each project Rank the projects according to the PI Choose the optimal combination of projects. No problem, since a part of project may also be undertaken

11. B . When projects are indivisible – Projects cannot be undertaken in part or partly Steps:- Construct a table showing feasible combination of the projects (whose aggregate of initial expenses does not exceed the funds available for investment) Determine the aggregate NPV of each Determine the combination having the highest aggregate NPV and it is the optimal project mix

12. Selecting the best It is not wrong to say that all the investment 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.

13. REFERENCE Introduction to capital rationing (Retrieved from, https://cleartax.in /g/terms/ ) capital rationing Selection process and other details ( https://www.ypuarticlelibrary.com/) capital rationing selection process

14. CONCLUSION 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 situation depends upon the criterion used for selection. 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.