Capital Rationing

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Internal capital rationing
Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing.
This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects.Another internal restriction for capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the management’s expectation on the rate of return will be cleared.
Generally internal capital rationing is used by a firm as a means of financial control.

Capital Rationing

Theoretical Background

When
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However, a limitation to using the profitability index is that the method assumes that the capital rationing constraint only applies to the current period and is only useful when selecting amongst relatively few projects.

In contrast, when capital rationing constraints occur over multiple periods and when there are numerous projects, Baumol and Quandt (1965) suggest that mathematical programming may be used to evaluate investments. The linear programming technique is widely used as the model is specifically designed to search through combinations of projects achieving the highest NPV whilst subject to a budget constraint. However, Brealy et al (2008) note that a main disadvantage to using linear programming may be the models can be highly complex and costly.

Empirical Evidence

Several U.S. surveys examine capital rationing in the overall investigation of the capital budgeting process. The following conclusions have been reached with regards to prevalence of capital rationing, the dominant causes and tools used in capital rationing analysis.

Prevalence of Capital Rationing

Empirical evidence indicates that capital rationing is prevalent amongst firms. It was concluded that between 50 and 75% of firms operate under the capital constraint as found by Fremgen (1975) and Petty, Scott & Bird (1975). Further support for this notion was found
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