Summary of Last Lecture:. Cash flows relevant to NPV Project timing on the cash flows relationship Steps involved in preparing pro forma cash flow statement. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL. Learning Objectives:.
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1. The best project may have a very high initial investment and you may not have that money. So, you are forced to reject that project as an option.
2. The company does not have the human resource, knowledge, or talent, which is required to undertake the project. The project might have high NPV but if you cannot manage it, you are forced not to invest in that project.
3. The companies have the prevailing fear of debt. In case of Muslim countries, there is a major issue of “Riba” (interest) among Muslim investors and the companies due to this religious constraint choose not to borrow money.
That is the reason that in many Muslim countries capital rationing has an ethical bases attach to it. Usually, the investors in these countries invest in the equity based investments as it has a risk of profit or loss in that kind of investment. We will discuss this topic in the upcoming lectures.
Now, it is important from you to remember that companies have different constraints, which keep them from investing in the best projects. The fear of debt is justified because when we discuss about the risk in upcoming lectures you find out that when a company takes on debt its future cash flows become more risky.
Therefore, there is a possibility of default due to which there is a fear of debt. These are various reasons due to which company decides not to invest in the project with the highest NPV and some of them involve capital rationing decisions as the following example shows.