Question

Captial Rationing as described in Chapter 7 is said to involve a high degree of subjective judgement. Do you think this makes it an unreliable method of evaluating investment opportunities, relative to the simple method of Net Present Value? What would convince you to put more confidence in this method?

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Answer 1

Capital rationing is essentially a management approach to allocating available funds across multiple investment opportunities, increasing a company's bottom line. The combination of projects with the highest total net present value (NPV) is accepted by the company. The number one goal of capital rationing is to ensure that a company does not over-invest in assets. Without adequate rationing, a company might start realizing decreasingly low returns on investments and may even face financial insolvency.

Capital rationing usually involves a high degree of subjective judgement as it relies upon the assessment of management or the project planning committee based on the combined/average NPVs of the on going or probable future projects. But this DOES NOT make the process of rationing unreliable as it involves a thorough assessment of the future projects and cost of capital involved in taking up each of th project.

The Capital rationing takes into consideration all the permutations and combinations of existing and future projects in order to make the company select a COMBINATION of projects which have the higher NPV value which is backed by the DIVERSIFICATION of risk strategy in comparing with the simple investment in project having the highest NPV which may have high risk of not achieving the required return on capital. This would convince a company to adopt the policy of capital rationing in contradiction with Simple NPV investment