Building in Capital Rationing Constraints into Analysis

We recommend that firms separate the capital rationing constraint from traditional investment analysis so they can observe how much these constraints cost. In the simplest terms, the cost of a capital rationing constraint is the total net present value of the good projects that could not be taken for lack of funds. There are two reasons why this

4 When capital rationing constraints occur over multiple periods, and there are dozens of projects, mathematical programming has been suggested as a solution by Baumol and Quandt (1965).

knowledge is useful. First, if the firm is faced with the opportunity to relax these constraints, knowing how much these constraints are costing the firm will be useful. For instance, the firm may be able to enter into a strategic partnership with a larger firm with excess funds and use the cash to take the good projects that would otherwise have been rejected, sharing the net present value of these projects. Second, if the capital rationing is self-imposed, managers in the firm are forced to confront the cost of the constraint. In some cases, the sheer magnitude of this cost may be sufficient for them to drop or relax the constraint.

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