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If possible, please explain with an example and also provide the important tools used while doing capital rationing.
A situation in investment appraisal or capital budgeting in which acceptable investments (capital investment opportunities whose projected rate of return exceeds the firm’s risk-adjusted cost of capital) compete for a limited amount of funds available for capital spending. The implication is that the costs of raising new capital are prohibitively high relative to expected returns. The ranking of projects competing for limited funds is called the profitability index.
The act of placing restriction on the amount of new investment or projects undertaken by a company.This is acomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on the specific sections of the budget.OR it Is a strategy used by organization attempting to limit the costs of their own Investments.
Tools of capital Rationing:
1.Net present value
2.Profitability Index
3.Internal rate of Return
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In an Investment Appraisal if a company have two or more project with positive NPV but limited funds, the company has to decide the project with highest positive Profitability Index i.e. Highest possible NPV per Unit of currency invested.
Limiting a company's new investments, either by setting a cap on parts of the capital budget or by using a higher cost of capital when weighing the merits of potential investments. This might happen when a company has not enjoyed good returns from investments in the recent past. Capital rationing also could take place if a company has excess production capacity on hand.
Capital Rationing is resorted to when on account of certain of some technical parameters the Establishment find it difficult to raise the required funds for the completion of a project(s), Eg. In anticipation of an approval for improvement in the "Authorised Capital" (pending or dismissal) company could not go for public or could not find out alternative course to raise the funds for an ongoing project, it require a prioritisation for already available funds on its project(s) to run the ongoing project. This happens at times when the sanctions are inordinately delayed or when the cost of the project escalated due to unavoidable circumstances that could not judge calculations at the time of Budgeting for the proposal.
