The Two-Stage Process

At the same time, the two criteria mentioned above suggest a two-stage solution to the problem of capital rationing. 

Firstly, projects that may yield below a certain cut-off rate (or the minimum required/acceptable rate of return) should be pruned off, since satisfying a project at any lower rate of return would result in insufficient funds to invest in projects with higher rates of return. Incidentally, this leads to two fundamental concepts reflected in practice : 

• the greater the spread (or difference) between the cut-off rate and cost of capital, the greater the pressure on the firm's management to increase the supply of funds by employing/securing outside funds, which, in turn, would generally spiral up the cost of capital; and 
• whenever the supply does not satisfy the demand, the cost of capital remains as the door or bottom line under [we are not saying - ''  the cut-off rate. In such a case, the problem extends not only to just increasing the supply but also to meet demands for all (or most) projects promising rates of return down through to the cost of capital (which would be increasing as the supply is increased). 

For the purpose of this first stage, a demand schedule is compiled collating the budgetary requests for the investment funds requested for the forthcoming period for each project, together with the merits of each [usually in the form of expected rate of return (as IRR) or BCR (PI) based on a stipulated MARR] and laddering them in decreasing order of the merit. This organisation of the laddered increments of demand can be presented graphically also by plotting the merit (on y-axis) against cumulative amounts of demand (on x-axis) - on the lines of an "Exceedence Curve". Some would prefer to draw the laddered curve for all projects presented for consideration and decide on the pruning off based on information worked out from the curve. 

Secondly, either through the BCR (or PI) or the NPV, appropriations must be made to projects (retained after the firstxtage) in the order of their highest contribution to the wealth of the shareholders. 

There is yet another view too on this two-stage process as follows. The first stage is effected through IRR or BCR (or PI); and to effect the second stage through NPV considerations.