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Capital rationing can apply to a single period, or to
multiple periods. Single-period capital rationing
occurs when there is a shortage of funds for one
period only.
Multi-period capital rationing is where there will
be a shortage of funds in more than one period.
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It is not wrong to say that all the investments with
positive NPV should be accepted but at the same
time the ground reality prevails that the availability
of capital is limited. The calculation and method
prescribes arranging projects
descending(downward) order of their profitability
based on IRR, NPV and PI and selecting the optimal
combination.
.
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The (IRR) on a project is the rate of return at
which the projects NPV equals zero.
For the IRR, the decision rules are as
follows: If IRR > expect rate, accept the
project
If IRR< expect rate, reject the project
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The difference between the present value of cash
inflows and the present value of cash outflows. NPV is
used in capital budgeting to analyze the profitability
of an investment or project.
Projects with NPV > 0 increase
stockholders return
Projects with NPV < 0 decrease
stockholders return
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For one year project
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In case of projects which are divisible (in which
we can complete some part of the project) . We
use the profitability index in order to find the
optimal project mix.
Definition of 'Profitability Index'
An index that attempts to identify the relationship
between the costs and benefits of a proposed project
through the use of a ratio calculated as:
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Decision Rule
Accept a project if the profitability index is greater
than 1, stay indifferent if the profitability index is
zero and don't accept a project if the profitability
index is below 1.
Profitability index is sometimes called benefit-cost
ratio too and is useful in capital rationing since it
helps in ranking projects based on their per dollar
return.
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Profitability Index 1000/2000=50 % 1000/4000=25%
ALL 1/4
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In case of non divisible projects we don’t have
the option of completing a part of the project.
So in this case we have to use the trial and
approach method to find out the best possible
alternatives given the limited amount of capital.
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