# Capital rationing. Capital Rationing Decision Process 2019-01-26

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## Capital Rationing

For discounting the future cash inflows, an appropriate discount rate is used which is usually the weighted average cost of capital. In case of mutually exclusive projects, the project yielding the highest internal rate of return is selected provided it is more than the weighted average cost of capital. Example: Following example clearly shows how capital rationing takes place in selection of certain investment project among group of available options. The company would have the option to produce each and every one of those patents; however, some might be more profitable than others. Net present value method is an absolute measure as it finds the monetary amount of difference between the present value of expected cash inflows and present value of expected cash outflows whereas profitability index is a relative measure as it finds the ratio.

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## Capital Rationing

We can try to find out the internal rate of return by trying different discount rates until the net present value of the project is zero or close to zero. Finally a special parameter of capital rationing is considered which is the percentage of total budget available being invested if the three projects are availed. Solution: Subtract the growth rate from the discount rate and treat the first period's cash flow as a perpetuity. Only one project can be accepted which is the most profitable among the other alternative projects which meet the investment criteria. Now similar process will be applied to the second and third options.

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## Capital Rationing

This idle money can finally be deposited into bank account for earning minimum return of 9 to 10% because there is no other investing option for it. For example in particular country food rationing is done. Capital rationing is a business strategy that a company uses when it places limits or restrictions on the amount of funds available for investment in new projects. Capital rationing is most common when a company's previous investments have not performed well. In such case two projects with different sizes of cash flows are compared. By implementing them with an investment of Rs. Problem: a Calculate the following for both proposals: i the payback period to one decimal place ii the average rate of return on initial investment, to one decimal place.

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## NPV Investment Appraisal Method & Capital Rationing

All the independent projects can be accepted if they meet the investment criteria and can be pursued simultaneously. Hard capital rationing is a process where business sets out a budgetary process, declaring the maximum amount of capital it will spend on a particular venture. The only alternative is to scrap the assets and incur heavy loss. The company has rationed its capital so that its existing investments allow it to pay out increasing dividends to its shareholders over the long-term. It calculates the average annual accounting profit the project would generate in relation to the average investment in the project or its average cost. The company has appropriate levels of capital to invest in different projects. The real rate measures the return in constant price level terms.

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## Capital Rationing Example and Reason to Choose

At the end of the fourth year, the machine in the project can earn a scrap value of Rs 100000. By doing capital budgeting it can be determined whether the potential long-term investment projects of the company are worth pursuing or not. The subject matter is difficult to grasp by nature of the topic covered and also because of the mathematical content involved. For example, raising the cost of capital from 10 percent to 5 percent would demand the company see a 5 percent higher return on any future investment than on those in the past. In case of mutually exclusive projects, the project yielding the highest average rate of return is selected.

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## Chapter 6

However, the use of that capital in those projects may not be equal. Your weighted average cost of capital is 3. Independent projects are the projects that do not compete with each other in such a way that the acceptance of one rejects the others. Beyond the point k o: project A is superior to project B, therefore project A is preferred to project B The two methods do not rank the projects the same. Often, it would be good to know what the present value of the future investment is, or how long it will take to mature give returns. That is, capital rationing occurs when a company's management places a maximum amount on new investments it can make over a given period of time. Sometimes two or even all the three criteria may result in the same solution, while at other times the solutions may be totally different, especially when the number of viable projects is large.

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## What is Capital Rationing?

As an individual, you have to prioritize and spend your budget wisely between your personal wants and needs. Internal Factors : Capital rationing is also caused by internal factors which are as follows: i Reluctance to take resort to financing by external equities in order to avoid assumption of further risk. Example: Suppose there are two projects A and B having different timing of cash flows. 路 It may lead to excessive investment in short-term projects. 路 It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment.

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## What is Capital Rationing? definition and meaning

In Keymer Farm's case, the cash flows are expressed in terms of the actual dollars that will be received or paid at the relevant dates. In this situation, issuing more stock could dilute the shareholders and cause the business to be less successful when it comes to maximizing shareholder wealth. Capital budgeting is the process of planning and taking decisions regarding the long-term investments of the company in fixed assets. Theoretically, projects should be undertaken to the point where the return is just equal to the cost of financing these projects. If the average rate of return is more than the minimum acceptable average rate of return decided by management, the project is accepted and if the average rate of return is less than the minimum acceptable rate of return decided by management, the project is rejected. The general theory of corporate finance is that a business would be successful anytime it sought to make a profit by selling a product. 路 It implicitly assumes stable cash receipts over time.

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## Capital rationing process

In this situation, the company would be constrained because of a non-monetary resource, namely engineers. Capital rationing is a process through which a limited capital budget is allocated between different projects in a way that maximizes the shareholder's wealth. 路 It takes no account of the length of the project. Therefore, the company needs to ration its capital and invest in projects efficiently, so it increases its bottom line, allowing it to either increase its dividend yield or increase its actual dividend per share. The cash inflows and outflows are brought to their present values by using an appropriate discount rate which is usually weighted average cost of capital. Thus, the company could sell 100 widgets make million dollars or it could sell five tidbits and make million dollars. If the standards are drafted in a manner that accurately reflects the current condition of the company, then there is a good chance the right types of investments will be considered.

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## capital rationing Archives

The following flowchart portrays the capital rationing decision process: Capital Rationing Decision Process New Page 2 More study material from this topic: A D V E R T I S E M E N T Financial Accounting Topics ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- Managerial Accounting Topics ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- ----------------------------------------------------------------------------. The company cannot undertake 4 project B because of lack of funds. Fifth year generates cash inflow of Rs 100000 whereas only Rs 50000 500000-450000 remains to be recovered. Capital Rationing:- Capital rationing is a situation in which the company may not be able to undertake all the profitable capital investment projects because of lack of adequate funds to finance all the profitable projects. The money rate measures the return in terms of the dollar, which is falling in value.

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