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Capital Rationing:

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Learning Objectives of this article:

  1. Define and explain capital rationing decision process?

Definition and Explanation:

Capital rationing is the process by which management allocates available investment funds among competing capital investment proposals. Normally, management uses various combinations of the valuation methods in developing an effective approach to capital rationing.

In capital rationing, an initial screening of alternative proposals is usually performed by establishing minimum standards for the cash payback and the average rate of return methods. The proposals that survive this initial screening are further analyzed using the net present value and internal rate of return methods. Throughout the capital rationing process, qualitative factors related to each proposal should also be considered. For example the acquisition of new, more efficient equipment that eliminates several jobs could lower employee morale to a level that could decrease over all plant productivity. alternatively, new equipment might improve the quality of the product and thus increase consumer satisfaction and sales.

The final step in the capital rationing process is to rank the proposals according to management's criteria, compare the proposals with the funds available, and select the proposals to be funded. The unfunded proposals may be considered if funds later become available. The following flowchart portrays the capital rationing decision process:

Capital Rationing Decision Process

capital rationing decision process

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More study material from this topic:

Methods for the evaluation of capital investment analysis
Average rate of return or accounting rate of return method
Cash payback method
Net present value method
Internal rate of return method
Simple interest
Future value of a single sum
Future value of an annuity
Present value of a single sum
Present value of an annuity
Qualitative consideration in capital investment analysis
Capital investment analysis and unequal proposal lives
Capital rationing decision process
Difference between simple interest and compound interest
Difference between nominal and effective interest rate
Future value of $1 table
Present value of $1 table
Present value of ordinary annuity table
Future value of ordinary annuity table



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