Capital rationing is a situation where a constraint or budget ceiling is placed on the total size of capital expenditures during a particular period. Often firms draw up their capital budget under the assumption that the availability of financial resources is limited.
Under this situation, a decision maker is compelled to reject some of the viable projects having positive net present value because of shortage of funds. It is known as a situation involving capital rationing.
Two different types of capital rationing situation can be identified, distinguished by the source of the capital expenditure constraint.
1. External Factors
Capital rationing may arise due to external factors like imperfections of capital market or deficiencies in market information which might have for the availability of capital.
Generally, either the capital market itself or the Government will not supply unlimited amounts of investment capital to a company, even though the company has identified investment opportunities which would be able to produce the required return. Because of these imperfections the firm may not get necessary amount of capital funds to carry out all the profitable projects.
2. Internal Factors
Capital rationing is also caused by internal factors which are as follows:
- Reluctance to take resort to financing by external equities in order to avoid assumption of further risk
- Reluctance to broaden the equity share base for fear of losing control.
- Reluctance to accept some viable projects because of its inability to manage the firm in the scale of operation resulting from inclusion of all the viable projects.