A firm in hard rationing must select projects that promise the most value for its limited funds, prioritizing profitability index values over a straightforward acceptance of all positive NPV projects. Companies raise capital through investors, profits, loans, and stocks, and they must navigate imperfect information and various trade-offs when sourcing their capital.
When a firm faces hard rationing, it implies that there is a strict limit to the amount of external financing they can secure for their capital projects. In this scenario, a firm must prioritize the allocation of its limited funds. Typically, the projects with the highest profitability index values are prioritized, as these are most likely to create the most value for shareholders. However, this does not mean that all projects with a positive Net Present Value (NPV) will be accepted. Due to the scarcity of funds, some divisions within the firm may receive an amount for capital expenditures that is less than the total value of its positive NPV projects, highlighting the need for careful selection and strategic financial planning.
Companies can raise financial capital through various methods: from early-stage investors, by reinvesting profits, by borrowing through banks or bonds, and by selling stock. The decision on which method to use often takes into account the costs involved, the need to repay with interest or dividends, and maintaining control of the company. For startups and businesses not yet generating profits, this task can be especially challenging, requiring careful consideration and strategic financial planning.
Patterns in how firms choose their sources of financial capital often reflect imperfect information, where those running the firm have more insight into potential future profits than outside investors. This asymmetry emphasizes the importance of a firm's internal decision-making regarding its investments and the trade-offs between different sources of capital.