This document discusses capital rationing, which refers to situations where a company has a limited budget to invest in projects, even if those projects would have a positive net present value. It defines capital rationing and provides reasons why it may occur, such as imperfect capital markets or self-imposed restrictions. It also describes two approaches to selecting projects under capital rationing - when projects can be divided or are indivisible. The optimal approach is to choose the combination of projects that yields the highest overall net present value within the available funds.

1. DR. M0HAMED KUTTY KAKKAKUNNAN
ASSOCIATE PROFESSOR
P.G. DEPT. OF COMMERCE
NAM COLLEGE KALLIKKANDY
KANNUR – KERALA - INDIA

2. CAPITAL RATIONING
What is the objective of financial management?
How wealth is maximized?
To maximize wealth, the firm has to invest in
those projects having positive NPV and the
firm has to invest funds in all projects until the
NPV of the last project (marginal project) is
zero
Now consider the following situation

3.  No problem if the company has sufficient funds
Suppose, the firm has only Rs. 200 lakhs; the
firm cannot invest in or undertake all projects
which have positive NPV or IRR above the cost
of capital
In this case the firm has to reject project “B” – a
profitable investment project due to lack or
insufficiency of capital
Further, cannot maximize the wealth
 Such a situation warrants capital rationing

4. Meaning and Definition
• Rationing is the process of allocating scarce
resources on the basis of priority based on certain
criterion
• It is a situation when the company cannot undertake
all investment projects with positive NPVs.
• As “a situation where insufficient funds can be made
available to finance all the prima facie profitable
projects”.
• “a situation where a constraint or a budget ceiling is
placed on the size of capital expenditure during a
particular period”

5. • It refers to the selection of the investment
proposals in a situation of constraint on
availability of capital funds, to maximize the
wealth of the company by selecting those
projects which will maximize the overall NPV
of the concern
• Under this situation the management has to
decide the profitable investment
opportunities and determine the combination
of projects which yields highest NPV, within
the available funds

6. Reasons (factors) for Capital Rationing
a. External factors –
Imperfections in capital markets - capital
market factors
b. Internal factors –
Self imposed restrictions by the management

7. Selection of Project
Under capital rationing management has to
determine not only profitable investment
opportunities but also decide to obtain that
combination of investment projects which
yields highest NPV within the available funds
by ranking them according to their relative
probabilities
May face two situations :-
A. Projects are divisible
B. Projects are indivisible

8. A. When projects are divisible
Steps
i. Calculate Profitability Index of each
project
ii. Rank the projects according to the PI
iii. Choose the optimal combination of
projects. No problem, since a part of
the project may also be undertaken

9. B. When projects are indivisible – Projects cannot
be undertaken in part or partly
Steps:-
i. Construct a table showing feasible combination
of the projects (whose aggregate of initial
expenses does not exceed the funds available
for investment)
ii. Determine the aggregate NPV of each
combination
iii. Determine the combination having the highest
aggregate NPV and it is the optimal project mix