Capital budgeting decision

Ranking will only be possible, if the following conditions hold: If the NPV, IRR and PI rank a particular investment to be superior to others such that if they consistently rank the certain investment as the best, then you take it up. However situation occurs when you get mixed signals.

CAPITAL BUDGETING UNDER THE CONDITION OF CAPITAL RATIONING

Capital rationing is the process of allocating the limited amount of funds to investments. In practice managers are faced with a problem of allocating capital to various opportunities due to constraints of limited sources of funds. Capital rationing occurs when a firm can’t undertake all viable investments due to insufficient funds for capital expenditure. The insufficiency of funds could be due to internal or external factors.

INTERNAL FACTORS

1. A risk profile of the manager.

Risk averse managers will not go to raise funds from the markets (money or capital markets) even when they are available.

2. Internal borrowing restrictions

These could be imposed by financial managers or could be in the memorandum of association, article of association or board restriction

EXTERNAL FACTORS

1. Capital market imperfections e.g. lack of adequate information, high cost of capital etc.

2. Absence or lack of capital markets in some situations.

 

ACTIONS TO TAKE DURING CAPITAL RATIONING

Capital rationing implies that you adjust your acceptance criteria and you must accept investment as a bundle which mixes the following:

1. A bundle that gives a highest NPV contribution.

2. A bundle which exhaust the available fund as much as possible.

The above two conditions now become the criteria of acceptance.

 

CAPITAL RATIONING COULD BE IN A SINGLE PERIOD OR IN SEVERAL PERIODS.

Single period capital rationing is when you have limited funds in first year, whereas multiple periods capital rationing occurs even in subsequent years.