The technique of capital budgeting is applied to select the best project giving a positive return over the time. But what happens when there are many good projects chosen by capital budgeting technique and budget for investment is limited but of course, there is hardly much cash available so as to invest in all projects. Then firms have to choose from profitable opportunities as firm is having limited number of financial resources.

The major Question which arises in front of any company is that:

“WHAT TO DO IN SUCH SITUATIONS?”

When because of external or self-imposed (internal) reasons a firm does not obtain necessary funds to invest in all profitable projects, such a situation in CAPITAL BUDGETING is known as CAPITAL RATIONING.

CAPITAL RATIONING IS: “MANAGEMENT’S  APPROACH TO

ALLOCATING  AVAILABLE FUNDS  AMONG COMPETING INVESTMENT PROPOSALS;

ONLY THE  PROPOSALS THAT MAXIMIZE THE  TOTAL NET PRESENT VALUE (NPV) OF THE INVESTMENT  ARE SELECTED.”

FEATURES OF CAPITAL RATIONING•Generally, capital rationing is utilized as a means of putting a limit or cap on the portion of the existing budget that may be used in acquiring a new asset.•Since capital rationing is all about setting criteria that any investment opportunity must meet before the company will seriously entertain the purchase, many businesses choose this strategy as their guiding process for any acquisitions. •Using the basic principles of the technique, a company can develop a list of standards that must be addressed before any capital purchase. 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.

TYPES OF CAPITAL RATIONING

STEPS INVOLVED IN CAPITAL RATIONING ARE:

PROJECT INITIAL CASH

OUTLAY

YEAR 1 YEAR 2 YEAR 3

A 1,00,000 60,000 50,000 40,000

B 50,000 20,000 40,000 20,000

C 50,000 20,000 30,000 30,000

1. Ranking of different investment proposals2. Selection of the most profitable investment proposalRanking of different investment proposalsThe various investment proposals should be ranked on the basis of their profitability. Ranking is done on the basis of NPV, Profitability index or IRR in the descending order.Profitability index as the basis of Capital RationingThe following details are available:

YEAR CASH

INFLOWS

PV FACTOR @

15%

PV OF CASH

INFLOW

1 60,000 0.870 52,200

2 50,000 0.756 37,800

3 40,000 0.658 26,320

TOTAL 1,16,320

NPV 16230

PROJECT A

PROFITABILITY INDEX= PV OF CASH INFLOW/PV OF CASH

OUTFLOWS= 1,16,320/1,00,000=1.1632

PROJECT B

YEAR CASH

INFLOWS

PV FACTOR @

15%

PV OF CASH

INFLOW

1 20,000 0.870 17,400

2 40,000 0.756 30,240

3 20,000 0.658 13,160

TOTAL 60,800

NPV 10800

PROFITABILITY INDEX= PV OF CASH INFLOW/PV OF CASH OUTFLOWS

=60800/50000=1.216

YEAR CASH

INFLOWS

PV FACTOR @ 15% PV OF CASH

INFLOW

1 20,000 0.870 17,400

2 30,000 0.756 22,680

3 30,000 0.658 19,740

TOTAL 59,280

NPV 9,280

PROFITABILITY INDEX= PV OF CASH INFLOW/PV OF CASH OUTFLOWS

= 59280/50000=1.1964

Let us assume that the firm is forced to resort Let us assume that the firm is forced to resort to capital rationing because the total funds to capital rationing because the total funds available for execution of project is only available for execution of project is only rs.1,00,000.rs.1,00,000.

PROJECT NPV PROFITABILITY INDEX

ABSOLUTE RANK ABSOLUTE RANK

A 16,320 1 1.163 3

B 10,800 2 1.216 1

C 9,280 3 1.1964 2

SELECTING THE PROJECT::

Limitations of profitability index:1.Multi period capital constraint2.Project indivisibility

It does not seem to be a serious problem in practice.When companies faces the problem of shortage of funds, they use simple rules of choosing projects rather than the complicated mathematical models.In study of Indian companies,•Most of the companies do not reject the project just on the basis of capital shortage.•Most of the companies do not use mathematical approaches to select projects . the bases to chose the projects are:

1. Profitability2. Priorities set by management3. Experience.

•Generally companies do not reject the profitable projects under capital rationing they postpone them till the funds become available.