Page 175 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

Notes

Notes Many firms’ capital constraints are ‘Soft’. They reflect no imperfections in capital
markets. Instead they are provisional limits adapted by management as an aid to financial
control. Soft rationing should never cost the firm anything. If capital constraints become
tight enough to hurt in the sense that projects with significant positive NPV’s are passed
up then the firm raises more money and loosens the constraint. But when it can’t raise
more money, then it faces hard rationing. ‘Hard’ capital rationing always reflects on
market imperfection a barrier between the firm and capital markets, which can be attributed
to non-availability of market information, investor attitude etc.
There are various ways of resorting to capital rationing. For instance, a firm may effect capital
rationing through budgets. Capital rationing may also be exercised by following the concept of
“responsibility accounting”, whereby management may introduce capital rationing by
authorizing a particular department to make investment only up to a specified limit, beyond
which the investment decisions are to be taken up by higher-ups.
In capital rationing, it may also be more desirable to accept small investment proposals than a
few large investment proposals so that there may be full utilization of budgeted amount. This
may result in accepting relatively less profitable investment proposals if full utilization of
budget is a primary consideration.
Similarly, capital rationing may also mean that the firm foregoes the next most profitable
investment following after the budget ceiling, even though it is estimated to yield a rate of
return much higher than the required rate of return. Thus, capital rationing does not always lead
to optimum results.

Example: S. Ltd. has 10,00,000 allocated for capital budgeting purposes. The following
proposals and associated profitability indexes have been determined:
Project Amount Profitability
( ) Index
1 3,00,0.00 1.22
2 1,50,000 0.95
3 3,50,000 1.20
4 4,50,000 1.18
5 2,00,000 1.20
6 4,00,000 1.05

Which of the above investments should be undertaken? Assume that projects are indivisible and
there is no alternative use of the money allocated for capital budgeting:
Solution:

We should go in for projects priority-wise based on PI Index:
Project PI Investment Priority Sum Total of NPV
Cash Inflows
1 1.22 3,00,000 I 3,66,000 66,000
3 1.20 3,50,000 2 4,20,000 70,000
5 1.20 2,00,000 2 2,40,000 40,000
4 1.18 4,50,000 3 5,31,000 81,000
6 1.05 4,00,000 4 4,20,000 20,000

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