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Balance Sheet \$type=three\$count=6\$author=hide\$comment=hide\$label=hide\$date=hide\$show=home\$s=0

One of  my UK student wants to know the capital rationing with simple example. before studying  the example, please read following introduction of capital rationing.

Capital rationing exists when investor is interested to invest his limited fund in most profitable investment proposal. In this case, a firm may be confronted with more “desirable” projects than it is willing to finance.

Now, We can explain capital rationing more deeply with following simple example:

Capital Rationing: An Example:  (Firm’s Cost of Capital = 12%)

Independent projects ranked according to their IRRs:

Project Project Size→ IRR

E \$20,000→ 21.0%
B 25,000 →19.0
G 25,000→ 18.0
H 10,000→ 17.5
D 25,000 →16.5
A 15,000→ 14.0
F 15,000 →11.0
C 30,000 →10.0

No Capital Rationing - Only projects F and C would be rejected. The firm’s capital budget would be \$120,000.

Existence of Capital Rationing - Suppose the capital budget is constrained to be \$80,000. Using the IRR criterion, only projects E, B, G, and H, would be accepted, even though projects D and A's IRR is higher than our cost of capital but we can not include because of our capital budget is limited upto \$ 80000.

{*Also note, however, that a theoretical optimum could be reached only be evaluating all possible combinations of projects in order to determine the portfolio of projects with the highest NPV.}

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