Project Selection Under Capital Rationing

Project Selection Under Capital Rationing

1 Capital Rationing

Capital rationing refers to a situation where the firm is constrained for external, or self imposed, reasons to obtain necessary funds to invest in all investment projects with positive net present value (NPV). Under capital rationing, the management has not simply to determine the profitable investment opportunities, but it has also to decide to obtain that combination of the profitable projects which yields highest net present value (NPV) within the available funds.

Why capital rationing?

Capital rationing may rise due to external factors or internal constraints imposed by the management. Thus there are two types of capital rationing.

^v   External capital rationing

^v   Internal capital rationing

External capital rationing

External capital rationing mainly occurs on account of the imperfections in capital markets. Imperfections may be caused by deficiencies in market information, or by rigidities of attitude that hamper the free flow of capital. The net present value (NPV) rule will not work if shareholders do not have access to the capital markets. Imperfections in capital markets alone do not invalidate use of the net present value (NPV) rule. In reality, we will have very few situations where capital markets do not exist for shareholders.

Internal capital rationing

Internal capital rationing is caused by self imposed restrictions by the management. Various types of constraints may be imposed. For example, it may be decide not to obtain additional funds by incurring debt. This may be a part of the firm‘s conservative financial policy.