M2A1 Discussion Capital Rationing
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Peer 1
Capital Rationing
Christopher Copenhaver posted Mar 22, 2018 7:41 PM
MEMORANDUM
TO: YXZ, Manager
FROM: Chris Copenhaver
Date: March 22, 2018
SUBJECT: Capital Rationing
Capital rationing is a process through which a limited capital budget is allocated between different projects in a way that maximizes the shareholders’ wealth. The capital budgeting development and critical methods are the equivalent for both insubstantial long-term resources capital spending. Capital budgeting has a dynamic impact on incremental cash flows on the product, projection, - tax. Minimizing principal mistakes must include the following:
1. Cash flows are solely relevant to the type of organization and outcome the organization is looking for.
2. Cash flows must not be based on accounting net income but on capital budgeting.
Financial managers will continue to safeguard shareholder interest by following these rules to account for uncertainty.
Capital rationing is a method used to select a project mix in a situation when the total funds available for investment are less than total net initial investment needed by all the projects under consideration. It involves calculation of profitability indices for all projects and selecting projects that lead to highest combined net present value.
In order to maximize shareholders' wealth, the company has to accept projects that maximize total value added. For this, it needs to rank the projects in the descending order of their profitability indicators and accept projects with higher profitability indicators till there are not enough funds available for the next project.
References
Obaidullah, J. (2015) XplainD. Retrieve from http://xplaind.com/497949/capital-rationing
Gitman, L. J., and Forrester, Jr., J.R. “A Survey of Capital Budgeting Techniques Used by Major U.S. Firms.” Financial Management, Fall 1977, pp. 66–71. Retrieved from https://digitalbookshelf.argosy.edu/#/books/0558302580/content/element/2873?locs[]=0-8&locs[]=9-2&q=appendix+2A
Peer 2
M2A1: Capital Rationing
Jiaying Wang posted Mar 23, 2018 5:10 AM
Memo
To: XXX, Manager
From: Jiaying Wang
CC: Capital Rationing
Date: 23/03/2018
Without capital rationing: all projects with NPV>=0 should be accepted. With capital rationing: project ranking becomes important. (Because not all acceptable projects can be undertaken). In the case of capital rationing, managers use a number of capital budgeting methods such as net present value (NPV), internal rate of return (IRR), profitability index (PI), payback, and discounted payback, etc. Due to the budget allocation ceiling for projects eligible for capital investment, the company may have to abandon some projects whose internal rate of return is higher than the total cost of the company. Capital rationing refers to the situation in which a company is unable to bear all confirmed NPV positive projects due to shortage of funds. When a company allocates capital, it only selects projects that can bring maximum profits to the company (Sanjay, 2018). The DCF criteria include two widely used discounted cash flow techniques other than net present value: internal rate of return and the PI or benefit-cost ratio. With capital rationing, a company will not be able to accept all profitable investment projects. To select some investment projects and reject other investment projects should compare profitable projects. Therefore, capital allocation will involve two steps:
1. Rank items according to a certain degree of profitability. 2. Select items in descending order of yield until funds are used up.
Although the project can be ranked by the NPV or internal interest rate or profit index, for the internal rate of return, the preference is a period of time, because it believes that business people can easily understand. Others, on the other hand, advocate using the earnings index on the net present value. It is said that the net present value is an absolute measure of profitability, while the profitability index determines the relative profitability, that is, the ratio of wealth per rupee of existing investment in the future (Meena, Tashu, 2018).
Reference: Meena, Tashu, (2018). Useful Notes on the 2 Important Reasons for Capital Rationing. Received from: http://www.shareyouressays.com/knowledge/useful-notes-on-the-2-important-reasons-for-capital-rationing/116341
Sanjay Bulaki Borad, (2018).Capital Rationing. Received from: https://efinancemanagement.com/investment-decisions/capital-rationing
