Hard Rationing

With hard rationing, a business cannot raise capital for a project under any circumstances. For large, healthy corporations, this situation probably does not occur very often. This is fortunate because, with hard rationing, our DCF analysis breaks down, and the best course of action is ambiguous.

The reason DCF analysis breaks down has to do with the required return. Suppose we say our required return is 20 percent. Implicitly, we are saying we will take a project with a return that exceeds this. However, if we face hard rationing, then we are not going to take a new project no matter what the return on that project is, so the whole concept of a required return is ambiguous. About the only interpretation we can give this situation is that the required return is so large that no project has a positive NPV in the first place.

Hard rationing can occur when a company experiences financial distress, meaning that bankruptcy is a possibility. Also, a firm may not be able to raise capital without violating a preexisting contractual agreement. We discuss these situations in greater detail in a later chapter.

hard rationing

The situation that occurs when a business cannot raise financing for a project under any circumstances.

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