Capital Rationing
Internal capital rationing
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.
Capital Rationing
Theoretical Background
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
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.
Capital Rationing
Theoretical Background
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
References: Baumol, W, J., & Quandt, R,E. (1965). Investment and Discount Rates under Capital Rationing – A Programming Approach. Economic Journal, 75, 317-329 Bierman, H, & Smidt, S (1960) Damadoran, A. (2001). Corporate Finance: Theory and Practice. 2nd Edition, John Wiley & Sons, Inc. 362-369 Fremgen, J Gitman, L. J. & Forrester, J. R. (1977). A survey of capital budgeting techniques used by major US firms. Financial Management, 6 (3), 66-71. Gitman, L. J. & Mercurio, V. A. (1982). Cost of capital techniques used by major US firms: Survey and analysis of Fortune 's 1000. Financial Management. 11 (4), 21-29. Mukherjee, T., & Henderson, G. (1987). The Capital Budgeting Process: Theory and Practice. Interfaces, 17(2), 78-90 Mukherjee, T., & Vineeta, L Petty, J. W; Scott, D. E; and Bird, M. R. 1975, "The capital expenditure decision-making process of large corporations," The Engineering Economist, Vol. 20, No. 3 (Spring), pp. 159-172 Zhang, G