Chapter 5 • Practical aspects of investment appraisal
5.8 Capital rationing
In Chapter 4 we saw that businesses will maximise the wealth of their shareholders by
undertaking all investment opportunities that have a positive NPV when discounted
at the appropriate cost of capital.
In some circumstances the business may be unable or unwilling to undertake all
such opportunities because it cannot or does not wish to raise finance to the level
required. This is known as capital rationing. Where it cannot raise the finance because
sources of supply are limited, the situation is known as hard capital rationing. Where
the constraint is self-imposed because, for example, the business feels that it does not
have sufficient management talent to expand beyond a certain point, it is referred to
as soft capital rationing.
It can be argued that there is no such thing as hard capital rationing since it is
always possible to raise finance from somewhere to finance a project. If the project is
viewed as risky, the finance may be expensive in terms of the cost of capital, but
finance is always available at some price. If the project’s anticipated cash flows, when
discounted at this high cost of capital, cannot produce a positive NPV, the project
should be rejected. This, however, is always the position with any type of project at
any time: if it cannot produce a positive NPV it should be rejected.
Research evidence suggests that, in real life, hard capital rationing is rare, finance
seeming to be available for viable projects (Pike and Ooi 1988).
Soft capital rationing may also arise where, though finance is available, the business
might find it expensive or inconvenient to raise it at the time that the investment
opportunity is first recognised. The business may, for example, find it more economic
to raise the finance in large blocks rather than piecemeal. Most instances of capital
rationing seem to be of the soft variety, and Arnold and Hatzopoulos (2000) found that
with nearly half of the businesses that they surveyed, soft capital rationing sometimes
leads to rejection of viable projects.
One way or another, capital rationing means that there are more calls on finance
than there is finance available.
Irrespective of whether there are hard or soft constraints, capital rationing requires
that the basic NPV rule cannot be applied without the modification. The nature of
modification depends on whether the constraint is to operate for just one year only or
is to persist for longer.Single-period capital rationing
Where there is single-period capital rationing, projects should be ranked according to
the NPV per £ of scarce initial investment capital.‘
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