Soft Rationing

The situation we have just described is called soft rationing. This occurs when, for example, different units in a business are allocated some fixed amount of money each year for capital spending. Such an allocation is primarily a means of controlling and keeping track of overall spending. The important thing to note about soft rationing is that the corporation as a whole isn't short of capital; more can be raised on ordinary terms if management so desires.

If we face soft rationing, the first thing to do is to try to get a larger allocation. Failing that, one common suggestion is to generate as large a net present value as possible within the existing budget. This amounts to choosing those projects with the largest benefit-cost ratio (profitability index).

Strictly speaking, this is the correct thing to do only if the soft rationing is a one-time event, that is, it won't exist next year. If the soft rationing is a chronic problem, then something is amiss. The reason goes all the way back to Chapter 1. Ongoing soft rationing means we are constantly bypassing positive NPV investments. This contradicts our goal of the firm. If we are not trying to maximize value, then the question of which projects to take becomes ambiguous because we no longer have an objective goal in the first place.

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