Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing. This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects.Another internal restriction for capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the management’s expectation on the rate of return will be cleared. Generally internal capital rationing is used by a firm as a means of financial control.
When evaluating capital investments, a firm may often be faced with the possibility that the amount of capital it can devote to new investments is limited. Furthermore, the cash flows of most investment projects are uncertain and as such; the availability of outside capital to fund these risky projects may be constrained (Hillier, Grinblatt & Titman, 2008). These capital constraints often lead to the phenomenon of capital rationing in the capital budgeting process of a firm.
Capital rationing occurs when a firm is unable to invest in profitable projects as restrictions are placed on the amount of new investments to be undertaken by a firm when the supply of capital is limited (Damodaran, 2001). Theoretically, a firm should aim to maximize its value and shareholder wealth by choosing profitable projects. However, as funds are limited under capital rationing, all positive NPV projects may not be selected. Therefore, in efficient capital markets, capital rationing should not exist (Mukherjee & Hingorani, 1999). However many empirical studies based on capital budgeting surveys have shown that capital rationing is prevalent among firms (Mukherjee & Henderson, 1987). It is thus important to understand why capital rationing exists and which capital budgeting tools firms use when making optimal investment decisions in a capital-rationing environment.
Causes of Capital Rationing
There are two different situations in which capital rationing may exist, namely external and internal capital rationing (Bierman and Smidt, 1960). External capital rationing or “hard rationing” implies that a firm may have a shortage of capital due to the firm’s inability to raise funds in external equity markets when facing severe capital market imperfections (Brealey, Myers & Allen, 2008). In contrast, internal capital rationing or “soft rationing” occurs through restrictions imposed by the firm’s management. This occurs when management decides to voluntarily limit the total amount of funds committed to investments by “fixing” the budget at a predetermined level (Zhang, 1997). This decision to self-impose a budget restriction may be recognized as management’s need to exercise financial control over the expenditures of divisions within the firm (Brealey, Myers & Allen, 2008). Another internal restriction imposed by management, as discussed by Bierman and Smidt (1960), occurs when the firm sets a “cut-off rate” for investments that is higher than the firm’s cost of capital (using a higher hurdle rate for investments than the cost of capital). Thus the firm is restricted to selecting only those projects which will meet management’s expected rate of return.
Project Selection in Capital Rationing
When incorporating the capital rationing constraint into project evaluations, the traditional analysis techniques, such as NPV, may prove to be inadequate as these capital budgeting techniques are based on the assumption that all profitable projects will be accepted (Damodaran, 2001). The two main measures used when evaluating investments under capital rationing constraints are the profitability index and mathematical programming techniques.
The profitability index is the simplest method of including capital rationing...