Capital Rationing

Many firms operate under capital rationing. Firms ration capital because more often than not firms do not have unlimited funds to invest. Therefore, not all acceptable projects can be actually accepted. This is, of course, contradictory with goal of maximizing shareholders value.

We can formally define the rationing of capital as follows: It is a situation when firms do not accept all acceptable projects due to a limited amount of funds or due to limits imposed on investments. The goal is to select portfolio of projects with the highest net present value.

Under situations involving scarce capital, businesses will select a portfolio of projects with the highest NPV and which does not exceed the allocated budget. There are two commonly used techniques to select projects in these situations, the net present value NPV approach and the internal rate of return (IRR) approach.

The IRR approach graphs return against the total investment on the investment opportunities schedule (IOS) and by drawing the budget constraint shows the group of projects that are acceptable to be invested in. The NPV approach ranks projects by IRR and than generates a portfolio of projects with the highest overall present value.

When selecting projects, the net present value (NPV) approach is preferred because it maximizes shareholders’ returns whereas an internal rate of return (IRR) approach just generates a portfolio of acceptable projects.

 

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