Capital Rationing
Capital Rationing
Many companies specify an overall limit on the total budget for capital spending. There is no conceptual justification for such budget ceiling, because all projects that enhance long run profitability should be accepted.
The factors for putting limit
• Net present values or IRR may strongly influence the overall budget amount
• Top management’s philosophy toward capital spending.
• Same managers are highly growth minded whereas others are not.
• The outlook for future investment opportunities that may not be feasible if extensive current commitments are undertake.
• The funds provided by the current operations less dividends.
• The feasibility of acquiring additional capital through borrowing or sale of additional stock. Lead-time and costs of financial market transactions can influence spending.
• Period of impending change in management personnel, when the status quo is maintained.
• Management attitudes toward not.
Capital Rationing occurs when a company has more amounts of capital budgeting projects with positive net present values than it has money to invest in them. Therefore, some projects that should be accepted are excluded because financial capital is limited.
This is known as artificial constraint because the management may dictate the amount to be invested for project purposes.
It is also the artificial constraints because the amount is not based on the product marginal analysis in which the return for each proposal is related to the cost of capital and projects with net present values are accepted.
A company may adopt a posture of capital rationing because it is fearful of too much growth or hesitant to use external sources of financing.
Types o ...