Capital Budgeting

Capital budgeting is made up of two words ‘capital’ and ‘budgeting.’ In this

context, capital expenditure is the spending of funds for large expenditures like
purchasing fixed assets and equipment, repairs to fixed assets or equipment,
research and development, expansion and the like. Budgeting is setting targets for
projects to ensure maximum profitability.

What is Capital Budgeting?

Capital budgeting is a process of evaluating investments and huge expenses in

order to obtain the best return on investment. 

An organization is often faced with the challenges of selecting between two

projects/investments or the buy vs replace decision. Ideally, an organization
would like to invest in all profitable projects but due to the limitation on the
availability of capital an organization has to choose between different
projects/investments. Capital budgeting as a concept affects our daily lives.

Objectives of Capital Budgeting

Capital expenditures are huge and have a long-term effect. Therefore, while
performing a capital budgeting analysis an organization must keep the following
objectives in mind:

Selecting Profitable projects

An organization comes across various profitable projects frequently. But due to

capital restrictions, an organization needs to select the right mix of profitable
projects that will increase its shareholders’ wealth.
Capital Expenditure control

Selecting the most profitable investment is the main objective of capital

budgeting. However, controlling capital costs is also an important objective.
Forecasting capital expenditure requirements and budgeting for it, and ensuring
no investment opportunities are lost is the crux of budgeting.

Finding Right Sources for Fund

Determining the quantum of funds and the sources for procuring them is another
important objective of capital budgeting. Finding the balance between the cost of
borrowing and returns on investment is an important goal of Capital Budgeting.

Importance of Capital Budgeting

 Calculation of future cash flows: Capital Budgeting process takes into

account the expected future cash inflows and the expected future cash

outflows of the project by taking into account the discounted rate of return

and following the various techniques like calculation of net present value,

considering the internal rate of return, payback period, profitability index,

and accounting rate of return Thus, the organization get the idea about

present investment’s future total value and the net profitability by using

the process of capital budgeting.

 Helps in the long term goals of the organization: Capital Budgeting process

helps the organization for the long term decision making as well as in
 making the long term goals as it provides the idea of future costs and

growth taking into account the expected future cash flows. The making of

long term goals is the most important and sensitive area for any

organization and any wrong decision taken in this area can adversely affect

the long term profitability of the organization.

 Control of Expenditure: The capital budgeting process gives the idea of the

expected future cash inflows as well as expected future cash outflows. It

takes into account the investment cost for the project considering the other

related expenditures like Research & Development costs, running costs of

the project, etc. So, with this information, the organization can monitor the

total costs and have control of its future costs. The proper management

and control of the total costs is a very important factor for the growth and

efficiency perspective of the company.

 Helps in Permanent Decision Making: Generally, the Capital related

decisions are the permanent decisions taken by the organization as it

involves the large amount of investments and funds. Such decisions cannot

be reversed back in the future once they are taken. Hence, the process of

capital budgeting helps in effective decision making for such permanent

decisions of the organization.

 Wealth Maximization: The interest and the investment decisions of the

shareholders in the company depend on its long term investment decisions.

If the investments in the capital or other long term investments are done by

the company in the proper and planned manner, the confidence of the

shareholders gets boost up and thus they become more interested in

investing in the company thus resulting in the company’s wealth

maximization.

 Flow of information within the departments: The entire process of capital

budgeting involves numerous steps and ideas and a number of decisions

are taken by the different levels of the company. This allows the flow and

exchange of information within the various departments and thus increases

the connectivity between them.

 Protection to the large funds involved: As discussed above, there involves

a large amount of funds by the company in the acquisition of the capital

assets. Thus with the process of capital budgeting, that large financial

investment or a large amount of funds invested by the company gets

protected to a certain extent against any uncertainty in future.

 Protection against future risks: There are various risks that are associated

with capital acquisitions by the company as they all are related to some
 future events and uncertainty. Thus, the capital budgeting process helps

the organization in the advance assessment of those risks involved, and the

management of the company plans for the protection of such risks well in

advance to minimize its impact.

 New Opportunities in the market: With the introduction of the new project

in the market, there arises many job opportunities for the new employees

as well as the existing ones. This gives rise to the economic growth of the

country along with boosting up the morale of personals.

 Understanding the Complications of the projects: With the help of the

Capital budgeting process, the management of the company can have the

idea of different types of complications or Complexities that can be faced or

arise during the development of the project. Hence, the management can

have ready and advance strategies for dealing with such future

complexities arising from the project.

Capital Budgeting Process:

 Identifying Investment Oppurtunities

 Evaluation of all Investment Proposals
 Choosing the most profitable Investment
 Capital Budgeting and Apportionment
 Performance Review
Identifying Investment Oppurtunities

An organization needs to first identify an investment opportunity. An investment

opportunity can be anything from a new business line to product expansion to
purchasing a new asset.  For example, a company finds two new products that
they can add to their product line.

Evaluation of all Investment Proposals

Once an investment opportunity has been recognized an organization needs to

evaluate its options for investment. That is to say, once it is decided that new
product/products should be added to the product line, the next step would be
deciding on how to acquire these products. There might be multiple ways of
acquiring them. Some of these products could be:

 Manufactured In-house
 Manufactured by Outsourcing manufacturing the process, or
 Purchase from market

Choosing the most profitable Investment

Once the investment opportunities are identified and all proposals are evaluated
an organization needs to decide the most profitable investment and select it.
While selecting a particular project an organization may have to use the
technique of capital rationing to rank the projects as per returns and select the
best option available. In our example, the company here has to decide what is
more profitable for them. Manufacturing or purchasing one or both of the
products or scrapping the idea of acquiring both.
Capital Budgeting and Apportionment

After the project is selected an organization needs to fund this project. To fund
the project it needs to identify the sources of funds and allocate it accordingly.  
The sources of these funds could be reserves, investments, loans or any other
available channel.

Performance Review

The last step in the process of capital budgeting is reviewing the investment.
Initially, the organization had selected a particular investment for a predicted
return. So now, they will compare the investments expected performance to the
actual performance

In our example, when the screening for the most profitable investment
happened, an expected return would have been worked out. Once the
investment is made, the products are released in the market; the profits earned
from its sales should be compared to the set expected returns. This will help in
the performance review.

Capital Budgeting Techniques/ Methods

Any investment decision depends upon the decision rule that is applied under
circumstances. However, the decision rule itself considers following inputs.

Cash flows Project Life

 Discounting Factor

1. Cash flows
2. Project Life
3. Discounting Factor

The effectiveness of the decision rule depends on how these three factors have
been properly assessed. Estimation of cash flows requires immense
understanding of the project before it is implemented; particularly macro and
micro view of the economy, polity and the company. Project life is very important;
otherwise it will change the entire perspective of the project. So great care is
required to be observed for estimating the project life. Cost of capital is being
considered as discounting factor which has undergone a change over the years.
Cost of capital has different connotations in different economic philosophies.
Particularly, India has undergone a change in its economic ideology from a closed-
economy to open-economy. Hence determination of cost of
Capital would carry greatest impact on the investment evaluation.

Capital budgeting techniques (Investment appraisal criteria) under certainty can

also be divided into following two groups:
Non-Discounted Cash Flow Criteria
a. Pay Back Period (PBP)
b. Accounting Rate Of Return (ARR)
Discounted Cash Flow Criteria:
 a. Net Present Value (NPV)
b. Internal Rate of Return (IRR)
c. Profitability Index (PI)

Non-Discounted Cash Flow Criteria

Pay Back Period (PBP) : The pay back period (PBP) is the traditional method of
capital budgeting. It is the simplest and perhaps, the most widely used
quantitative method for appraising capital expenditure decision. It is the number
of years required to recover the original cash outlay invested in a project.
Methods to compute PBP:
There are two methods of calculating the PBP.
a. When Cash inflows are uniform:
The first method can be applied when the CFAT is uniform. In such a situation the
initial cost of the investment is divided by the constant annual cash flow: For
example, if an investment of Rs. 100000 in a machine is expected to generate
cash inflow of Rs. 20,000 p.a. for 10 years. Its PBP will be calculated using
following formula:
PBP = Initial Investment / Constant annual cash Flow = 100000/20000= 5 years
b. When Cash inflows are not uniform
The second method is used when a project’s CFAT are not equal. In such a
situation PBP is calculated by the process of cumulating CFAT till the time when
cumulative cash flow becomes equal to the original investment outlays.
For example, A firm requires an initial cash outflow of Rs. 20,000 and the annual
cash inflows for 5 years are Rs. 6000, Rs. 8000, Rs. 5000, Rs. 4000 and Rs. 4000
respectively. Calculate PBP. Here, when we cumulate the cash flows for the first
three years, Rs. 19,000 is recovered. In the fourth year Rs. 4000 cash flow is
generated by the project but we need to recover only Rs.1000 so the time
required recovering Rs. 1000 will be (Rs.1000/Rs.4000)  12 months = 3 months.
Thus, the PBP is 3 years and 3 months (3.25 years).

Initial outlay 20000

Year Cash Inflows Cumulative cash inflows
1 6000 6000
2 8000 14000
3 5000 19000
4 4000 23000
5 4000
4th year we need cash inflow =20000-19000=1000
In the first 3 month we can get the cash infklow of Rs1000
Payback Period =3 +(3/12) =3+.25 =3.25 Years
Decision Rule:
The PBP can be used as a decision criterion to select investment proposal. If the
PBP is less than the maximum acceptable payback period, accept the project. If
the PBP is greater than the maximum acceptable payback period, reject the
project. This technique can be used to compare actual pay back with a standard
pay back set up by the management in terms of the maximum period during
which the initial investment must be recovered. The standard PBP is determined
by management subjectively on the basis of a number of factors such as the type
of project, the perceived risk of the project etc. PBP can be even used for ranking
mutually exclusive projects. The projects may be ranked according to the length
of PBP and the project with the shortest PBP will be selected.

Merits:
1. It is simple both in concept and application and easy to calculate.
2. It is a cost effective method which does not require much of the time of finance
executives as well as the use of computers.
3. It is a method for dealing with risk. It favours projects which generates
substantial cash inflows in earlier years and discriminates against projects which
brings substantial inflows in later years . Thus PBP method is useful in weeding
out risky projects.
4. This is a method of liquidity. It emphasizes selecting a project with the early
recovery of the investment.
Demerits:
1. It fails to consider the time value of money. Cash inflows, in pay back
calculations, are simply added without discounting. This violates the most
basic principles of financial analysis that stipulates the cash flows occurring
at different points of time can be added or subtracted only after suitable
compounding/ discounting.
2. It ignores cash flows beyond PBP. This leads to reject projects that generate
substantial inflows in later years. To illustrate, consider the cash flows of
twoprojects, “A” & “B”:

Year Project A Project B

0 -200000 -200000
 1 100000 100000
2 60000 60000
3 40000 40000
4 20000 80000
5 60000
6 70000

Payback period of project A is 3 years

Payback period of project B is also 3 years

The PB criterion prefers A, which has PBP of 3 years in comparison to B, which has
PBP of 4 years, even though B has very substantial cash flows in 5&6 years also.
Thus, it does not consider all cash flows generated by the projects.

3. It is a measure of projects capital recovery, not profitability so this can not

be used as the only method of accepting or rejecting a project. The
organization need to use some other method also which takes into account
profitability of the project.
4. The projects are not getting preference as per their cash flow pattern. It
gives equal weightage to the projects if their PBP is same but their pattern
is different. For example, each of the following projects requires a cash
outlay of Rs. 20,000. If we calculate its PBP it is same for all projects i.e. 4
years so all will be treated equally. But the cash flow pattern is different so
 in fact, project Y should be preferable as it gives higher cash inflow in the
initial years.
Year Project X Project Y Project Z
1 5000 8000 2000
2 5000 6000 4000
3 5000 4000 6000
4 5000 2000 8000
5 5000

Payback period of project X = 4 years

Payback period of project X = 4 years
Payback period of project Z = 4 years
5. There is no logical base to decide standard PBP of the organization it is
generally a subjective decision.
6. It is not consistent with the objective of shareholders’ wealth maximization.
The PBP of the projects will not affect the market price of equity shares.

Uses:
The PBP can be gainfully employed under the following circumstances.
1. The PB method may be useful for the firms suffering from a liquidity crisis.
2. It is very useful for those firms which emphasizes on short run earning
performance rather than its long term growth.
3. The reciprocal of PBP is a good approximation of IRR which otherwise
requires trial & error approach.

Payback is considered a good approximation of the rate of return under following

two conditions.
 1. The life of the project is too large or at least twice the pay back period.
2. The project generates constant annual cash inflow.
Though pay back reciprocal is a useful way to estimate the project’s IRR but
the major limitation of it is all investment project does not satisfy the
conditions on which this method is based. When the useful life of the
project is not at least twice the PBP, it will always exceed the rate of return.
Similarly, if the project is not yielding constant CFAT it can not be used as
an approximation of the rate of return

Discounted Payback Period:

One of the major limitations of PBP method is that it does not take into
consideration time value of money. This problem can be solved if we
discount the cash flows and then calculate the PBP. Thus, discounted
payback period is the number of years taken in recovering th investment
outlay on the present value basis. But it still fails to consider the cash flows
beyond the payback. For example, one project requires investment of Rs.
80,000 and it generates cash flow for 5 years as follows.

Years 0 1 2 3 4 5 Simpl Discounte

e PBP d
PBP
Cash flow (80000 2200 3000 4000 32000 16000
) 0 0 0
Pv rate 0.951 0.906 0.863 0.822 0.784
@5%
PV 2092 2718 3452 26304 12544
2 0 0
Cumulativ 2092 4810 8262 10892 12147
e PV of 2 2 2 6 0
Cash flow
Year Inflows Cumulative inflows
1 22000 22000
2 30000 52000
3 40000 92000
4 32000 124000
5 16000 140000
Inflows needed in 3 year = 80000-52000=28000
Payback period = 2 years + (1/40000*28000) =2+0.7=2.7 years

Payback period using discounted method = 2 years + 1/34520 * (80000-48102) =2

years + 1/34520 *31898 =2 years + 0.92 = 2.92 years

Accounting/Average Rate of Return (ARR):

This method is also known as the return on investment (ROI), return on capital
employed (ROCE) and is using accounting information rather than cash flow.

Meaning:
The ARR is the ratio of the average after tax profit divided by the average
investment.

Method to compute ARR: = (Average annual profit after Tax / Average

investment) x100

For example,
A project requires an investment of Rs. 10,00,000. The plant & machinery
required under the project will have a scrap value of Rs. 80,000 at the end
 of its useful life of 5 years. The profits after tax and depreciation are
estimated to be as follows:

Year 1 2 3 4 5

PAT (Rs) 50000 75000 125000 130000 80000

Ans:

Average annual profit after tax = Total annual profit/ No of years =

( 50000+75000+125000+130000+80000 ) /5 = 460000/5 = Rs 92000

Average investment = (Initial investment + value of the investment at the

end)/2 = (1000000+80000) /2 =Rs 590000

ARR = (92000/590000) x 100 = 15.59%

Decision Rule:

The ARR can be used as a decision criterion to select investment proposal.

If the ARR is higher than the minimum rate established by the
management, accept the project.
If the ARR is less than the minimum rate established by the management,
reject the project.

The ranking method can also be used to select or reject the proposal using
ARR. It will rank a project number one if it has highest ARR and lowest rank
would be given to the project with lowest ARR.

Merits:

1. It is simple to calculate.
2. It is based on accounting information which is readily available and
familiar to businessman.
 3. It considers benefit over entire life of the project.

Demerits:

1. It is based upon accounting profit, not cash flow in evaluating projects.

2. It does not take into consideration time value of money so benefits in the
earlier years or later years cannot be valued at par.
3. This method does not take into consideration any benefits which can
accrue to the firm from the sale or abandonment of equipment which is
replaced by a new investment. ARR does not make any adjustment in this
regard to determine the level of average investments.
4. Though it takes into account all years income but it is averaging out the
profit.
5. The firm compares any project’s ARR with the one which is arbitrarily
decided by management generally based on the firm’s current return on
assets. Due to this yardstick sometimes super normal growth firm’s reject
profitable projects if it’s ARR is less than the firm’s current earnings.

Use:
The ARR can better be used as performance evaluation measure and
control devise but it is not advisable to use as a decision making criterion
for capital expenditures of the firm as it is not using cash flow information.

Discounted Cash Flow Criteria:

These are also known as modern or time adjusted techniques because all these
techniques take into consideration time value of money.

(a) Net Present Value (NPV):

The net present value is one of the discounted cash flow or time-adjusted
technique. It recognizes that cash flow streams at different time period differs in
value and can be computed only when they are expressed in terms of common
denominator i.e. present value.

Meaning:
The NPV is the difference between the present value of future cash inflows and
the present value of the initial outlay, discounted at the firm’s cost of capital. The
procedure for determining the present values consists of two stages. The first
stage ninvolves determination of an appropriate discount rate. With the discount
rate so selected, the cash flow streams are converted into present values in the
second stage.

Method to compute NPV:

The important steps for calculating NPV are given below:

1. Cash flows of the investment project should be forecasted based on realistic

assumptions. These cash flows are the incremental cash inflow after taxes and are
inclusive of depreciation (CFAT) which is assumed to be received at the end of
each year. CFAT should take into account salvage value and working capital
released at the end.

2. Appropriate discount rate should be identified to discount the forecasted

cash flows. The appropriate discount rate is the firm’s opportunity cost of
capital which is equal to the required rate of return expected by investors
on investments of equivalent risk.

3. Present value (PV) of cash flows should be calculated using opportunity

cost of capital as the discount rate.

4. NPV should be found out by subtracting present value of cash outflows from
present value of cash inflows. The project should be accepted if NPV is positive
(i.e. NPV >0)

Decision Rule:

The present value method can be used as an accept-reject criterion. The

present value of the future cash streams or inflows would be compared
with present value of outlays. The present value outlays are the same as
the initial investment.
 If the NPV is greater than 0, accept the project.
If the NPV is less than 0, reject the project.

For example,
Calculate NPV for a Project X initially costing Rs. 250000. It has 10% cost of
capital. It generates following cash flows:

Year PV @ 10 % PV
Cash Inflows
1 90000 0.909 81810

2 80000 0.826 66080

3 70000 0.751 52570

4 60000 0.683 40980

5 50000 0.621 31050

272490

Net Present value = Present value of all cash inflows – Present value of all
cash outflows
=272490 -250000= Rs22490
As the NPV is greater than zero the project can be accepted.

Calculate NPV for a Project X initially costing Rs. 250000. It has 7.5% cost
of capital. It generates following cash flows:

Cash PV 7% PV 8% PV @ PV of
Year Inflows 7.5% cash
inflows
1 90000 0.935 0.926 0.9305 83745

2 80000 0.873 0.857 0.865 69200

3 70000 0.816 0.794 0.805 56350

4 60000 0.763 0.735 0.749 44940

5 50000 0.713 0.681 0.697 34850

289085

NPV = 289085 – 250000 = Rs39085

As the NPV is greater than zero we can accept the project.

Illustration 

Let us say Nice Ltd wants to expand its business and so it is willing to invest
Rs 10,00,000. The investment is said to bring an inflow of Rs.  1,00,000 in
first year, 2,50,000 in the second year, 3,50,000 in third year, 2,65,000 in
fourth year and 4,15,000 in fifth year. Assuming the discount rate to be 9%,
find whether the exansion is profitable or not.

Cash inflows PV @ 9% PV of Cash inflow

Year
1 100000 0.971 97100

250000 0.842 210500

2
350000 0.772 270200
3
265000 0.708 187620
4
415000 0.650 269750
5
1035170

PI = PV of cash inflows / Initail Outlay =1035170 /1000000 =1.035

As the PI is greater than the project can be accepted.

 NPV = 1035170 – 1000000 = 35170

As the NPV is greater than zero, then the expansion is profitable.

Illustration

The firm XYZ Inc. is considering two projects, Project A and Project B, and
wants to calculate the NPV for each project.
 Project A is a four-year project with the following cash flows in each of the
four years: Rs5,0000, Rs4,0000, Rs3,0000, Rs1,0000.
 Project B is also a four-year project with the following cash flows in each of
the four years: Rs1,0000, Rs3,0000, Rs4,0000, Rs6,7500
 The firm's cost of capital is 7 percent for each project, and the initial
investment is Rs10,0000.
The firm wants to determine and compare the net present value of these
cash flows for both projects. Each project has uneven cash flows.

Year Cash inlow Cash inlow PV @ PV of Cash PV of Cash

Project A Project B 7% inflow Project inflow Project
A B
1 50000 10000 0.935 46750 9350

2 40000 30000 0.873 34920 26190

3 30000 40000 0.816 24480 32640

4 10000 67500 0.763 7630 51503

Total 113780 119683

13780 19683
NPV
2 1
Pref/Rank

Merits:

This method is considered as the most appropriate measure of profitability due to

following virtues.
 1. It explicitly recognizes the time value of money.
2. It takes into account all the years cash flows arising out of the
project over its useful life.
3. It is an absolute measure of profitability.
4. A changing discount rate can be built into NPV calculation. This
feature becomes important as this rate normally changes because
the longer the time span, the lower the value of money & higher the
discount rate.
5. It is always consistent with the firm’s goal of shareholder’s wealth
maximization.

Demerits:

1. This method requires estimation of cash flows which is very difficult due
to uncertainties existing in business world due to so many uncontrollable
environmental factors.

2. It requires the calculation of the required rate of return to discount the

cash flows. The discount rate is the most important element used in the
calculation of the present values because different discount rates will give
different present values. The relative desirability of the proposal will
change with a change in the discount rate.

4. When projects under consideration are mutually exclusive, it may not give
dependable results if the projects are having unequal lives, different cash
flow pattern, different cash outlay etc.

5. It does not explicitly deal with uncertainty when valuing the project and the
extent of management’s flexibility to respond to uncertainty over the life of
the project

6. It ignores the value of creating options. Sometimes an investment that

appears uneconomical when viewed in isolation may, in fact, create options
that enable the firm to undertake other investments in the future should
market conditions turn favourable. By not accounting properly for the
options that investments in emerging technology may yield, naive NPV
analysis can lead firms to invest too little.
Internal Rate of Return (IRR):

This technique is also known as yield on investment, marginal productivity of

capital, marginal efficiency of capital, rate of return, and time-adjusted rate of
return and so on. It also considers the time value of money by discounting the
cash flow streams, like NPV. While computing the required rate of return and
finding out present value of cash flows-inflows as well as outflowsare not
considered. But the IRR depends entirely on the initial outlay and the cash
proceeds of the projects which are being evaluated for acceptance or rejection. It
is, therefore, appropriately referred to as internal rate of return. The IRR is usually
the rate of return that a project earns.

The internal rate of return (IRR) is the discount rate that equates the NPV of an
investment opportunity with Rs.0 (because the present value of cash inflows
equals the initial investment). It is the compound annual rate of return that the
firm will earn if it invests in the project and receives the given cash inflows.

Decision Rule:
When IRR is used to make accept-reject decisions, the decision criteria are as
follows:

If the IRR is greater than the cost of capital, accept the project.
If the IRR is less than the cost of capital, reject the project.

R1 =10% R2 = 20%

PV @ 10%
Year Cash InflowsPv @10% PV
1 50000 0.909 45450
2 100000 0.826 82600
3 200000 0.751 150200
278250
NPV 1 = 278200-250000=28200

PV @ 20%
Year Cash InflowsPV @ 20% PV
1 50000 0.833 41650
2 100000 0.694 69400
3 200000 0.579 115800
226850
NPV 2 = 226850 – 250000 = -23150

IRR = R1 +( NPV1 (R2 –R1 )% / (NPV 1 – NPV2)

= 10% + (78200(20-10) % / ( 28200 – (-23150)

=10 +5.5%
+ 15.5%

Merits:
1. It considers the time value of money and it also takes into account the total
cash flows generated by any project over the life of the project.
2. IRR is a very much acceptable capital budgeting method in real life as it
measures profitability of the projects in percentage and can be easily compared
with the opportunity cost of capital.
3. It is consistent with the overall objective of maximizing shareholders wealth.

Demerits:
1. It requires lengthy and complicated calculations.
2. When projects under consideration are mutually exclusive, IRR may give
conflicting results.
3. We may get multiple IRRs for the same project when there are
nonconventional cash flows especially.
4. It does not satisfy the value additivity principle which is the unique virtue of
NPV.

Profitability Index (PI):

Profitability Index (PI) or Benefit-cost ratio (B/C) is similar to the NPV approach. PI
approach measures the present value of returns per rupee invested. It is observed
in shortcoming of NPV that, being an absolute measure, it is not a reliable method
to evaluate projects requiring different initial investments. The PI method
provides solution to this kind of problem.

Meaning:
It is a relative measure and can be defined as the ratio which is obtained by
dividing the present value of future cash inflows by the present value of cash
outlays. Mathematically

PI = Present value of cash inflows/ Initial outlay

Decision Rule:

Using the PI ratio,

Accept the project when PI>1
Reject the project when PI <1
May or may not accept when PI=1, the firm is indifferent to the project.

Capital Rationing

Capital rationing is defined as the process of placing a limit on the extent of new

projects or investments that a company decides to undertake. This is made
possible by placing a much higher cost of capital for the consideration of the
investments or by placing a ceiling on a particular proportion of a budget.

Capital rationing is necessarily an approach of management in allocating the

funds available across various opportunities of investment, thereby enhancing
the bottom line of the company. The company will go on to accept the blend of
projects that have the net present value (NPV) on the higher side.
The primary intention of the capital rationing is to make sure that a company is
not going to invest heavily in assets. With insufficient rationing, a company may
go on to witness the returns provided by their investments going on the lower
side and may even reach a scenario where the company enters the stage of
financial insolvency.
Examples of Capital Rationing
For example, suppose ABC Corp. has a cost of capital of 10% but that the
company has undertaken too many projects, many of which are incomplete. This
causes the company's actual return on investment to drop well below the 10%
level. As a result, management decides to place a cap on the number of new
projects by raising the cost of capital for these new projects to 15%. Starting
fewer new projects would give the company more time and resources to
complete existing projects.
Types of Rationing
The first type of capital rationing is called as the hard capital rationing. This type
of rationing happens if a company is having issues with raising excessive funds,
either by means of debt or equity. The rationing happens from an external
dependence in order to cut down on expenses and may result in the shortage of
capital to raise enough money for projects in future.
The second kind of capital, rationing, is referred to as the soft capital rationing. It
is also called as the internal rationing. This happens because of the internal
policies of an organisation. A company that is financially conservative will have a
high required return on the capital invested in taking up projects in the coming
days, thereby imposing self capital rationing.