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 The act of placing restrictions on the amount of new


investments or projects undertaken by a company.
This is accomplished by imposing a higher cost of
capital for investment consideration.
 The situation that exists if a firm has positive NPV
Projects but cannot find the necessary financing.
For example, as division managers for a large
corporation, we
might identify $5 million in excellent projects, but find
that, for whatever reason, we can spend only $2
million. Now what? Unfortunately, for reasons we will
discuss, there may be no truly satisfactory answer.
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 Hard Capital Rationing: It is when the capital
infusion(mixture) is limited by external
sources.
 Hard rationing: The situation that occurs when a
business cannot raise financing for a project under
any circumstances.
 REASONS:
 Economic conditions (recession).
 Lack of security.
 Lack of or poor track record.
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 Soft Capital Rationing: It is when the restriction
is imposed by the management.
 Soft rationing: The situation that occurs when
units in a business are allocated a certain amount of
financing for capital budgeting.
 REASONS:
 Lack of management skills.
 Focus on Key areas.
 Too many projects undertaken.

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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

 For more than 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%

NPV of Project. 1000 1000

Initial investment.($) 2000 4000

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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