11 - Resource constraints and linear programming

Summary

So far we have assumed that the firm's market value or the shareholders' wealth is maximized by accepting every investment project that has a positive NPV. In the real world, however, there are limitations on the investment programme that prevent the firm from undertaking all such projects. There may, for example, be a limit on the amount of funds available for financing investment projects. This is often called capital rationing.

Clearly, capital rationing does exist in the real world. If projects have positive NPVs and both management and financiers are happy with the NPV estimates, then, in an efficient capital market, one would expect funds to be available for all positive NPV projects. Under these circumstances, capital rationing is irrational. Nevertheless, two types of capital rationing are often encountered. Sometimes, management imposes capital expenditure limits; this is called soft capital rationing. Sometimes, a firm is unable to raise funds to undertake all positive NPV projects, and this is referred to as hard capital rationing. Various reasons have been advanced as to why hard or soft capital rationing might exist (Weingartner, 1977).

Apparently viable projects can also be rejected because firms face various other resource constraints, such as the availability of particular types of labour and raw material. Government regulations or marketing strategies may also impose restrictions. Specific methods such as the profitability index, which involve ‘juggling’ positive NPV project expenditures to ensure that total combined NPV is maximized from the investment decision, can handle decisions associated with a single constraint.