Budget limit affects strongly firms' investment. The solution is shown to be the net present value, even under the capital rationing situations.
A firm should accept all investment projects with positive net present value in order to maximize the wealth of shareholders. The net present value rule tells us to spend funds in the projects until the net present value of the last project is zero.
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. 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 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.
External capital rationing
This 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 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 rule. In reality, we will have very few situations where capital markets do not exist for shareholders.
Internal capital rationing
This 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 firms conservative financial policy. Management may fix an arbitrary limit to the amount of funds to be invested by the divisional managers. Sometimes management may resort to capital rationing by requiring a minimum rate of return higher than the cost of capital. Whatever, may be the type of restrictions, the implication is that some of the profitable projects will have to be forgone because of the lack of funds. However, the net present value rule will work since shareholders can borrow or lend in the capital markets.
It is quite difficult sometimes justify the internal rationing. But generally it is used as a means of financial controls. In a divisional set up, the divisional managers may overstate their investment requirements. One way of forcing them to carefully assess their investment opportunities and set priorities is to put upper limits to their capital expenditures. Similarly, a company may put investment limits if it finds itself incapable of coping with the strains and organizational problems of a fast growth.