Is capital rationed? In other words, do firms have a limited amount of capital to invest? In theory, a firm should be able to raise capital for any positive NPV project that is identified. However, think for a few minutes about the variables that are inputs into the capital budgeting process. Are all of the inputs certain? Absolutely not, since many of our inputs are estimates and an estimate is an educated guess.
Capital rationing, or limiting the funds available for capital budgeting, can be imposed by management (soft rationing) or by the market (hard rationing). Soft rationing forces division managers to select only the best projects instead of a laundry list of projects. If a manager can make a particularly convincing case for more investment dollars, they may be awarded to that division. Hard rationing has the same impact but is due to the firm’s inability to procure additional investment dollars from the market; no additional funds will become available for any reason. Answer the following questions about capital budgeting.
1. What factors or variables can change that could alter the accept/reject decision?
2. How does capital rationing help us select only the best projects?
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