Fallout of Capital Rationing Homework Help

Fallout of Capital Rationing

Capital rationing limit is the amount to be spent on capital expenditure decisions. The firm may be such a limit primarily for two reasons : (i) there may be a paucity of funds and (ii) corporate managers/owners may be conservative and may be like to invest more than a specified/stated sum in capital projects at one point or time, they may like to accept projects with a greater margin of safety, measured by NPV.

Whatever might be the reasons for capital rationing, it usually results in an investment policy that is less than optimal. The reason is that capital rationing does not allow the business firm to accept all profitable investment projects which could add to net present value and, thus, add to the wealth or shareholders. In other words, capital rationing inflicts opportunity cost to the extent or NPV foregone on account of non-acceptance of otherwise acceptable (profitable) investment projects.

Another notable consequence is that capital rationing may lead to the acceptance of several small investment projects (promising higher return per rupee of investment) rather than a few large investment projects. Acceptance of such a package of investment projects is likely to have a bearing on the risk complexion of the business firm (perhaps it may decrease).

Finally, selection criterion of investment projects under capital rationing (based on one-period analysis) does not reckon intermediate cash inflows expected to be provided by an investment project. However, some investment projects may yield relatively higher CFAT in the initial/early years compared to other projects. Obviously, availability of such funds in the early years tends to reduce capital budgeting constraints of the early future as they can be used to finance profitable investment projects. For this reason, the management should consider more than one period in the allocation of limited capital for investment projects.

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