Capital rationing situations arise when a firm operates with a fixed budget. A firm cannot accept all projects which are expected to increase its present value. The constraints which lead to a decision to hold capital expenditure to a fixed sum arise due to market conditions or may be entirely self imposed.
“Capital rationing refers to a situation where the firm is constrained for external self imposed, reasons to obtain necessary funds to invest in all profitable investment projects”. Under capital rationing, therefore, the management has not simply to determine the profitable investment of opportunities but ranked them according to their relative profitabilities with limited funds, the firm must obtain the optimum combination of investment proposals.
Reasons for Capital Rationing:
Capital rationing may arise due to:
ADVERTISEMENTS:
1. External Factors
2. Internal Factors.
Image Source : 2m5luk39s2i73igy9p1csdms.wpengine.netdna-cdn.com
1. External Factors:
Mainly occurs due to the imperfection of the capital markets. Imperfections may be caused by deficiencies in market information’s, by rigidities that hamper the free flow of capital between firms, and by a difference between the interest rate of which the firm can obtain capital in the market (i.e., the borrowing rate) and the interest rate it could earn by lending its over capital to others in the market (i.e., the lending rate). The reason for this difference in rates is the transaction costs. Because of these imperfections, the firm is not able to obtain necessary capital to finance in profitable investment opportunities.
2. Internal Factors:
ADVERTISEMENTS:
Internal capital rationing is caused by self imposed restriction by management. It is quite difficult some times to find a rationale for such restrictions. Various types of restrictions can be imposed by management e.g. it may be decided not to obtain additional capital by incurring debt. This may be part of the firm’s conservative policy.
Similarly, the management may fix an arbitrary limit to amour, of funds to be invested by the divisional managers. Sometimes, management resort to capital rationing by requiring a minimum rate of return higher than the cost of capital. Whatever may be the type of internal restrictions, it has same effect as external capital rationing.
Selection of Proposals under Capital Rationing:
Under the capital rationing a firm would not be able to accept all profitable investment projects. To select some investment projects and to reject others, a comparison among the profitable projects should be made. The capital rationing will thus, involve two steps:
1. Ranking projects according to some measure of profitability and
ADVERTISEMENTS:
2. Selecting projects in the descending order of profitability until the funds are exhausted.
Although the projects can be ranked either by the net present value or the internal rate or the profitability index, preference is some time shown for the internal rate of return on the belief that it is easily understood by businessmen.
On the other hand, others advocate the use of profitability index over the net present value. It is said that the net present value is the absolute measure of profitability, while the profitability index determines the relative profitability, being a ratio of future wealth per rupee of present investment.