capital rationing

Capital rationing

Placing limits on the amount of new investment undertaken by a firm, either by using a higher cost of capital, or by setting a maximum on the entire capital budget or parts of it.

Capital Rationing

The act or practice of limiting a company's investment. That is, capital rationing occurs when a company's management places a maximum amount on new investments it can make over a given period of time. The two methods of capital rationing are forbidding investments over a certain amount or increasing the cost of capital for such investments. Capital rationing is most common when a company's previous investments have not performed well.

capital rationing

a situation where a firm selects an annual capital budget which is less than the amount required to undertake all INVESTMENTS promising a rate of return in excess of the cost of capital. For example, if a firm requires a minimum 20% return on any investment then all of the appropriate investment opportunities available to the firm which promise a return of 20% or more may involve a total expenditure of, say, £10 million. However, if the firm decides that it is willing to spend only £6 million, then it must rank investment opportunities in descending order of rate of return, undertaking those with the highest promised return and rejecting others even though the latter opportunities promise a re- turn greater than the 20% cost of capital. The firm is said to be in a situation of capital rationing because it is investing less than the amount dictated by usual profit maximizing criteria. See CAPITAL BUDGETING, INVESTMENT APPRAISAL.
References in periodicals archive ?
However, the analysis of Belgian firms' financial structure with respect to the introduction of ACE over a relatively short period can be biased by exogenous factors such as capital rationing, which followed the 2008 financial crisis.
Most Chinese firms (87 percent) indicated that debt is the largest source of their capital rationing. A majority of Chinese firms (52 percent) have an internally imposed debt limit, 20 percent have a debt limit imposed by external managers and 15 percent have debt limits imposed by an external agreement.
In "The Effect of Financing Sources on the Usefulness of Financial Reporting Quality in Guiding Investments," Kevin Sun shows that ineffective monitoring and capital rationing by shareholders and banks, due to information asymmetry, may result in a lack of management's investment responses to changes in growth opportunities.
Credit committees were often approving only 25 per cent of viable applications due to capital rationing and taking a very selective stance."
The continued impact of that capital rationing can be seen even now as some of the UK's biggest banks withdraw from parts of the SME lending market such as asset finance.
This is known as capital rationing. An executive planning committee may emerge from a lengthy capital budgeting session to announce that only four billion pesos (US$84Million) may be spent on new capital projects for a specific year.
The case provides an opportunity to consider the effects of capital rationing.
IRR has also been criticised because it doesn't always correctly evaluate mutually exclusive projects or ensure the best allocation of resources when capital rationing occurs.
The impact of liability risk on the cost of capital can be significant and may lead to capital rationing.
Finally, if paying too much in dividends leads to capital rationing constraints where good projects are rejected, there will be a loss of value (captured by the net present value of the rejected projects).
While it is typically assumed that all value-generating projects should be accepted, Shapiro addresses the important issue of limited project choice due to capital rationing or mutual exclusivity in the chapter's appendix.
They present the exercise in 12 chapters covering cash flow analysis; book rate of return and payback period; basics of discounting; evaluating projects and comparing alternatives; marginal cost, equivalent cost, and replacement analysis; after-tax analysis ; calculations in nominal and real terms--effects of inflation on profitability; impact of technological progress upon equivalent cost and replacement analysis; discount rate, cost of capital, and capital rationing; alternative methods and special cases in financing mix and project evaluation; interdependent projects and the use of optimization methods; and decision theory and real option analysis in the context of investment under uncertainty.

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