Friday, October 3, 2014

Capital Rationing

Generally, firms fix up maximum amount that can be invested in capital projects, during a given period of time, say 1 year. The firm then attempts to select a combination of investment proposals, that will be within the specific limits providing maximum profitability & put them in decending order according to their rate of return, such a situation is then considered to be capital rationing.
An oraganisation should accept all investments projects with positive NPV, with an objective to maximum the wealth of shareholders. However, there may be resourse constraints due to which a firm may have to select from among various projects with positive NPVs. Hence, there may arise a situation of capital rationing where there may be internal or external constraints on procurement of necessary funds to invest in all investment proposals with positive NPVs.
Example:-

Beta Ltd. is considering 5 capital projects for the years 2004, 2005, 2006 & 2007. The company is financed by equity entirely & its cost of capital is 12%. The expected cash flows of the projects are as follows:-
                                                Year & Cash Flows ( Rs. ‘000’)
Project       2004                         2005                           2006                               2007
X                (70)                            35                               35                                 20
Y                (40)                           (30)                             45                                  55
T                (50)                            (60)                             70                                  80
D                 -                               (90)                              55                                  65
Z                (60)                            20                               40                                   50
Note:- Figures in brackets represent cash outflows.

All projects are divisable size of investment can be reduced, if necessary in relation to avability of funds. None of the projects can be delayed or undertaken more than once.
Calculate which project Beta Ltd. should undertake if the capital available for investment is limited to Rs. 1,00,000 in 2004 & with no limitation in subsequent years.
Present value Factors are:-
Year                     2004                            2005                         2006              2007
Factor                  1.00                             0.89                           0.80              0.71

Solution:-
Computation of Net present value (NPV) & Profitabilty Index (PI)
Projects                                                             Discounted Cash Flows
                  2004           2005                        2006                           2007         NPV           PI
X               (70)             31.15                        28                           14.20         3.35         1.048
Y               (40)            (26.70)                      36                           39.05          8.35         1.125
T               (50)            (53.40)                      56                           56.80           9.40         1.091
D                -                 (80.10)                    44                          44.15          10.05        1.125
Z               (60)             17.80                       32                          35.50          25.30        1.422

                               Rationing of Projects in descending order of profitability index
Rank                1                                 2                               3                        4                   5
Projects           Z                                 D                              Y                        T                  X

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