Capital Rationing

In evaluating capital investments, we have implicitly assumed that investing capital in a good project has no effect on subsequent projects that the firm may consider. Implicitly, we are assuming that firms with good projects can raise capital from financial markets, at a fair price, and without paying transactions costs. In reality, however, it is possible that the capital required to finance a project can cause managers to reject other good projects because the firm has access to limited capital. Capital rationing occurs when a firm is unable to invest in projects that earn returns greater than the hurdle rates2. Firms may face capital rationing constraints because they do not have either the capital on hand or the capacity to raise the capital needed to finance these projects. This implies that the firm does not have — and cannot raise — the capital to accept the positive net present value projects that are available to it. A firm that has many projects and limited resources on hand does not necessarily face capital rationing. It might still have the capacity to raise the resources from financial markets to finance all these projects.

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