Explain Hard capital rationing and Soft capital rationing

The NPV decision rule to admit all projects with a positive net present value requires the existence of a perfect capital market where access to funds for capital investment isn't restricted. In practice companies are probable to find that funds available for capital investment are restricted or rationed.

Hard capital rationing is the term applied while the restrictions on raising funds are due to causes external to the company. For instance potential providers of debt finance may refuse to provide further funding because they regard a company as too risky. This possibly in terms of financial risk for instance if the company's gearing is too high or its interest cover is too low or in terms of business risk if they see the company's business prospects as poor or its operating cash flows as too variable. In practice huge established companies seeking long-term finance for capital investment are usually able to find it but small and medium-sized enterprises will find increase such funds more difficult.

Soft capital rationing refers to limits on the availability of funds that arise within a company and are imposed by managers. There are numerous reasons why managers might restrict available funds for capital investment. Managers may favour slower organic growth to a sudden increase in size arising from accepting several large investment projects. This cause might apply in a family-owned business that wishes to avoid hiring new managers. Managers may desire to avoid raising further equity finance if this will dilute the control of existing shareholders. Managers may desire to avoid issuing new debt if their expectations of future economic conditions are such as to suggest that an increased commitment to fixed interest payments would be unwise.

One of the major reasons suggested for soft capital rationing is that managers wish to create an internal market for investment funds. It is suggested that necessitating investment projects to compete for funds means that weaker or marginal projects with only a small chance of success are avoided. This permits a company to focus on more robust investment projects where the chance of success is higher1. This reason of soft capital rationing can be seen as a way of reducing the risk and uncertainty associated with investment projects as it leads to accepting projects with greater margins of safety.