ASSIGNMENT
OF
CORPORATE TAX PLANNING
ON
SUBMITED TO SUBMITED BY
PROF. DHIRAJ SHARMA KARANVIR KALRA
MBA-II(b)
5830
SCHOOL OF MANAGEMENT STUDIES
PUNJABI UNIVERSITY
PATIALA
CAPITAL RATIONING
Introduction:
Capital budgeting decisions involve huge outlay of funds. Funds available for projects may be
limited. Therefore, a firm has to prioritize the projects on the basis of availability of funds and
economic compulsion of the firm. It is not possible for a company to take up all the projects at a
time. There is the need to rank them on the basis of strategic compulsion and funds availability.
Since companies will have to choose one from among many competing investment proposal the
need to develop criteria for Capital rationing cannot be ignored. The companies may have many
profitable and viable proposals but cannot execute because of shortage of funds. Another
constraint is that the firms may not be able to generate additional funds for the execution of all
the projects. When a firm imposes constraints on the total size of firm’s capital budget, it is
requires Capital Rationing. When Capital is rationed there is a need to develop a method of
selecting the projects that could be executed with the company’s resources yet give the highest
possible net present value.
Meaning of Capital Rationing:
Because of the limited financial resources, firms may have to make a choice from among
profitable investment opportunities. Capital rationing refers to a situation in which the firm is
under a constraint of funds, limiting its capacity to take up and execute all the profitable projects.
Such as situation may be due to external factors or due to the need to impose internal constraints,
keeping in view of the need to exercise better financial control.
Why Capital Rationing
Capital Rationing may be due to
a. External factors
b. b. Internal constraints imposed by management
c. External Capital Rationing: External Capital Rationing is due to the imperfections of
capital markets Imperfection may be caused by:
a. Deficiencies in market information
b. Rigidities that hamper the force flow of Capital between firms.
When capital markets are not favourable to the company the firm cannot tap the capital
market for executing new projects even though the projects have positive net present values.
The following reasons attribute to the external capital rationing:
1. Inability of the firm to procure required funds from Capital market because the firm does
not command the required investor’s confidence.
2. National and international economic factors may make the market highly volatile and
instable.
3. Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the
market for funds.
4. High Cost of issue of Securities I,e High floatation cost. Smaller firms smaller firms may
have to incur high costs of issue of securities. This discourages small firms from tapping the
capital markets for funds.
Internal Capital Rationing: Impositions of restrictions by a firm on the funds allocated for
fresh
investment is called internal capital rationing. This decision may be the result of a conservative
policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount
that they can commit on new projects.
Another internal restriction for Capital budgeting decision may be imposed by a firm based on
the
need to generate a minimum rate of return. Under this criterion only projects capable of
generating the management’s expectation on the rate of return will be cleared. Generally internal
capital rationing is used by a firm as a means of financial control.
Steps involved in Capital Rationing
Steps involved in Capital Rationing are:
1. Ranking of different investment proposals
2. Selection of the most profitable investment proposal
Ranking of different investment proposals
The various investment proposals should be ranked on the basis of their profitability. Ranking is
done on the basis of NPV, Profitability index or IRR in the descending order.
Profitability index as the basis of Capital Rationing
The following details are available.
Cash inflow
Project Initial cash Year 1 Year 2 Year 3
outlay
a 100000 60000 50000 40000
b 50000 20000 40000 20000
c 50000 20000 30000 20000
Cost of capital is 15%
Year Cash inflow Pv factor at 15% Pv of cash inflow
1 60000 .870 52200
2 50000 .756 37800
3 40000 .658 26320
P.V of cash inflow 116320
Initial cash outlay 100000
NPV 16320
Profitability index= PV of cash inflows
PV of cash outflow
= 1,16,320 = 1.1632
100000
Project B
1 20000 .870 17400
2 40000 .756 30240
3 20000 .658 13160
PV of cash inflow 60800
Initial cash outlay 50000
NPV 10800
Profitability index = 60,800 = 1.216
50000
PROJECT C
Project B
1 20000 .870 17400
2 30000 .756 22680
3 30000 .658 19740
PV of cash inflow 59820
Initial cash outlay 50000
NPV 9820
Profitability index = 59,820 = 1.1964
50000
Ranking of Projects
Project NPV PROFITABILITY INDEX
Absolute Rank Absolute Rank
A 16320 1 1.1632 3
B 10800 2 1.216 1
C 9820 3 1.194 2
If the firm has sufficient funds and no capital rationing restriction, then all the projects can be
accepted because all of them have positive NPVs.
Let us assume that the firm is forced to resort to capital rationing because the total funds
available for execution of project is only Rs.1,00,000.
In this case on the basis of NPV Criterion, project A will be cleared. It incurs an initial cash
outlay
of Rs.1,00,000. After allocating Rs.1,00,000 to project A, left over funds is nil. Therefore, on the
basis of NPV criterion other projects i,e B & C cannot be taken up for execution by the firm. It
will
increase the net wealth of the firm by Rs.16,320.
On the other hand on the basis of profitability index, project B and C can be executed with
Rs.1,00,000 because both of them incur individually an initial cash outlay of Rs.50,000.
Therefore, with the execution of projects B and C, increase in net wealth of the firm will be
10800
+ 9820 = Rs20620
The objective is to maximize NPV per rupee of Capital and projects should be ranked on the
basis of the profitability index. Funds should be allocated on the basis ranks assigned by
profitability index.