Capital rationing means that there is not sufficient finance (capital) available to support all the projects proposed in an organisation. In an ideal world any project which can earn a positive net present value or earn an internal rate of return greater than the cost of capital should be able to find a source of finance because there are rewards to the providers of capital. However, the world is not ideal and there may be restrictions on capital for any of the following reasons:
There may be temporary uncertainty in the economy (perhaps over rates of interest or rates of foreign currency exchange) and lenders are limiting the amount that they will provide as long-term finance until the uncertainty is resolved. This is called ‘external’ capital rationing because it is beyond the control of the management of the organisation. The managers of the organisation may want to impose some overall limits to the extent of expansion or development in the organisation as a whole, perhaps to control the risk profile of the organisation as a whole. This is called ‘internal’ capital rationing because it is imposed from within the organisation.
In the public sector the government may wish to control the overall amount of borrowing by the public sector as a whole and accordingly it sets limits for financing new investment projects in each activity of the public sector. Is it essential to carry out the entire project that is planned? Could part of the project be started now and the rest deferred until capital is available? If the project is a divisible project then the separate parts may be evaluated separately. If the proposed project is a non-divisible project then it must be evaluated in total. The aim of evaluating projects under capital rationing is to obtain the highest possible net present value for the capital available. It may not be possible to obtain as much net present value as would be available in the absence of capital rationing. The...
Please join StudyMode to read the full document