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Capital Budgeting Under Capital Rationing

Capital Budgeting Under Capital Rationing:

Generally, firms fix up maximum amount that can be invested in capital projects, during a given period of time, say a year. The firm then attempts to select a combination of investment proposals, that will be within the specific limits providing maximum profitability, and put them in descending order according to their rate of return, such a situation is then considered to be capital rationing.

Capital Budgeting Under Capital Rationing

A firm should accept all investment projects with positive NPV, with an objective to maximize the wealth of shareholders. However, there may be resource constraints due to which a firm may have to select from among various projects with positive NPV s. Thus there may arise a situation of capital rationing where there may be internal or external constraints on procurement of necessary funds to invest in all investment proposals with positive NPVs.

Capital rationing can be experienced due to external factors, mainly imperfections in capital markets which can be attributed to non-availability of market information, investor attitude etc.

Internal capital rationing is due to the self-imposed restrictions imposed by management like not to raise additional debt or laying down a specified minimum rate of return on each project.

Capital Budgeting Under Capital Rationing

Capital rationing may also be introduced by following the concept of ‘responsibility accounting’, whereby management may introduce capital rationing by authorizing a particular department to make investment only upto a specified limit, beyond which the investment decisions are to be taken by higher-ups.

Capital Budgeting Under Capital Rationing

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