Capital rationing

Capital rationing occurs when a firm is unable to invest in projects

that earn returns greater than hurdle rates.
These sources are typically more severe for smaller firms and for
firms seeking equity financing.
There are two types of capital rationing
1. hard capital rationing.
2. soft capital rationing.
Hard capital rationing: Occurs when firms has many options for investment but is unable
to take them up either because of insufficient funds or because
capital markets are not favourable.
1.lack of standing in the market- cannot raise funds due to
credibility issues.
2. high flotation cost.

 Soft capital rationing: Occurs when firms has self imposed restrictions on funds
allocated for fresh investments.
Availability of funds or have the ability to procure the funds
from markets but they do not do so
Use retained earnings to foster growth

Capital rationing and choosing a

rule
If a business has limited access to capital and has a
stream of surplus value projects, it is much more likely
to use IRR as its decision rule.
Small, high-growth companies and private businesses
are much more likely to use IRR.
If a business has substantial funds on hand, access to
capital and limited surplus value projects, it is much
more likely to use NPV as its decision rule.
As firms go public and grow, they are much more likely
to gain from using NPV.

Example 1
Funds available for capital expenditure in a year are
estimated at Rs. 2,50,000 in a firm. The profitability index
(PI) with mutually exclusive investment proposals are:

The following investment proposals along

with their profitability index (PI) are: