Capital rationing

is the process of selecting the most

valuable projects to invest available
funds. In this process, managers use
a number of capital budgeting
methods such as cash payback
period method (CPPM), accounting
rate of return (ARR) method, net
present value (NPV) method and
internal rate of return (IRR) method.

Steps in capital rationing

Step 1: First of all, the alternative projects are
screened using payback period and
accounting rate of return methods.
Management sets maximum desired payback
period or minimum desired accounting rate of
return for all competing alternative projects.
The payback period or accounting rate of
return of various alternatives is then
computed and compared to the
managements desired payback period and
accounting rate of return.

Steps in capital rationing

Step 2:The projects that pass the initial test
in step 1 are further analyzed using net
present value
Step 3:The projects that survive in step 2
are ranked using a predetermined criteria
and compared with the available funds.
Finally, the projects are selected for funding.
The projects that remain unfunded may be
reconsidered on the availability of funds
internal rate of return methods.

Reasons for Capital Rationing:

There are situations in which after calculating the
IRR's and NPV's of different projects you are
forced not to invest in the best project. Some
reasons are
1. The best project may have a very high initial
investment and you may not have that money.
So, you are forced to reject that project as an
option.
2. The company does not have the human
resource, knowledge, or talent, which is required
to undertake the project. The project might have
high NPV but if you cannot manage it, you are
forced not to invest in that project.

Reasons for Capital

Rationing
3. The companies have the prevailing fear of debt. In
case of Muslim countries, there is a major issue of
"Riba" (interest) among Muslim investors and the
companies due to this religious constraint choose
not to borrow money.
Now, it is important from you to remember that
companies have different constraints, which keep
them from investing in the best projects.
These are various reasons due to which company
decides not to invest in the project with the highest
NPV and some of them involve capital rationing
decisions as the following example shows.

Example
There are 4 Projects (mutually exclusive
real asset projects) to choose from. Total
budget isRs.1, 000
Project
A 200
B 100
C 300
D 800

Investment
40%300
40%300
35%200
30%600

IRR NPV

Option 1:
If we pick Projects A, B, & C then we have to consider
what will be the combined NPV of these projects and
what average IRR will be of this portfolio or
combination of projects. Finally, we have to look an
interesting parameter for capital rationing which is
what percentage of total budget available is being
utilized if we invest in these projects.
Budget Utilization = 200+100+300 = 600 (out of
1000)
Total NPV of three projects = 300+300+200 = 800
Simple Average IRR = 38% = (40+40+35)/3 Nonweighted

Option 1
38% seems to be attractive IRR. NPV
of 800 looks good relatively to the
size of investments. Finally, we look
at percent budget utilization and for
this option
Budget Utilization = 200+100+300
= 600
This option is utilizing 60% of total
budget.

Option 2
Pick Projects A and D because they
have the highest NPV's.
Budget Utilization = 200+800 =
1000
Total NPV = 300+600 = 900
Average IRR = 35%

Option 3
: Pick Projects B and D because they
have the highest NPV's.
Budget Utilization = 100+800 = 900
Total NPV = 300+600 = 900
Average IRR = 35%

Summary of the options

Budget Utilization
Option 1
Rs.600 (60%)

Option 2
Rs.1000 (100%)

NPV

Avg IRR

Rs.800 38%

Rs.900 35%

Option 3
Rs.900 (90%)
Rs.900 35%
It is clear from the summery that option 2 is best
option. It carries the highest NPV which is Rs 900 and it
also has the highest budget utilization at IRR of roughly
35 %.

Why we not choose option 1:

Option no 1 has the highest IRR of
38% but the problem is that in option
1 our NPV is not the highest, rather,
it is lower than the option 2 and 3.
Secondly, Budget utilization is only
60% and the 40% of the money
available for investment is wasted
and is lying idle.