Capital rationing - Types
Shareholder wealth is maximised by taking on positive NPV projects. However, capital is not always available to allow this to happen.
In a perfect capital market there is always finance available - in reality there is not, there are 2 reasons for this:
HARD CAPITAL RATIONING
This is due to external factors such as banks won’t lend any more - why?
Reasons for Hard Capital Rationing
Industry wide factor (recession?)
Company has no/poor track record
Company has too low credit rating
Company has no assets to secure the loan
Capital in short supply (crowded out by government borrowing)
SOFT CAPITAL RATIONING
Company imposes it’s own spending restriction. (This goes against the concept of shareholder maximisation - which occurs by always investing in positive NVP projects ) - why?
Reasons for Soft Capital Rationing
Limited management skills in new area
Want to limit exposure and focus on profitability of small number of projects
The costs of raising the finance relatively high
No wish to lose control or reduce EPS by issuing shares
Wish to maintain s high interest cover ratio
“Internal Capital market” - deliberately restricting funds so competing projects become more efficient