Question

What is capital rationing? How capital budgeting projects are chosen when capital rationing exist? Explain.

Answer 1

Capital Rationing is term use in capital budgeting in which company act for making some limitation of placing restrictions on the amount of new investments or projects. Primary tool use for capital rationing is the increase the cost of capital. If cost of capital is high, then discounting rate will high so lots of project cannot be accepted.

When capital rationing exist capital budgeting projects are chosen based on Variaous capital budgeting measure.

. Net present value method

2. Internal rate of return method

3. Modified Internal rate of return method

4. Payback period method

5. Discounted payback method

6. Profitability index method.

From various measure of capital budgeting net present value is best measure of capital budgeting because of following reason.

1. net present value consider the reinvestment of cash flow at discount rate while other method IRR consider reinvestment at IRR rate

2. Net present value consider time value of money and consider whole period of cash flow which is not available with payback period and discounted payback period methods.

So, based on NPV project should be accepted if capital rationing exists.