194 Corporate Finance
Approach 1
Discount the negative cash flows to year 0 and then to the initial investment. It becomes a conventional
project. In the above example, discount the last year cash flow of Rs 220,000 to year 0, using the hurdle rate,
and add it to the initial investment of Rs 1 lac. If the IRR of the new series of negative cash flows followed
by positive cash flows is greater than cost of capital, the project can be accepted.
Approach 2
Move the positive cash flows to the year in which the negative cash flow occurs so that it becomes a positive
flow. The IRR of the conventional series is easy to find. In the above example, move the positive flow to the
second year, and add it to the negative cash flow. Assuming that the hurdle rate is 12 percent:
= 310,000 (1.12) – Rs 220000 = Rs 127200This is a conventional series with an initial outflow followed by a positive inflow of Rs 127,200 in year 2.
Find the IRR of this series. If it is greater than the cost of capital, the project can be accepted.
Time (^04)
Cash flow
100000 127200
)1(^2
127200
+r
= Rs 100000.CAPITAL RATIONING
In some circumstances, in choosing a set of investments, firms may be faced with limited amounts of capital.
As a result, some projects with positive NPV may be rejected. The situation where companies are constrained
to obtain funds to invest in all available positive NPV projects is called capital rationing. Capital rationing
is of two types: internal and external. External capital rationing occurs due to capital market imperfections
like ill-pricing of securities, flotation costs, etc. Internal capital rationing occurs from self-imposed restrictions
by top management. A company may decide not to raise additional capital—either debt or equity—and place
an arbitrary limit on the amount to be invested. The reluctance to go to the capital market could be due to the
fear of scrutiny by financial intermediaries or the fear of loss of control. In another type of internal capital
rationing, the company sets a cut off rate higher than the cost of capital due to which profitable projects may
have to be forgone. Recently a survey of Fortune 500 firms (results shown in Exhibits 9.7–9.9) was conducted
to find out whether capital rationing is internal or external, how firms decide on the budget amount and so on.^1
Quite often, the Profitability Index is suggested as the solution to dealing with capital rationing. PI is a
scaled measure. It is the NPV of an investment for every rupee of investment.
(^1) Mukherjee, T and V Hingorani (1999). ‘Capital Rationing Decisions of Fortune 500 Firms: A Survey’, Financial Practice
and Education, Summer.