Moral Hazard in Corporate Investment and the Disciplinary Role of Voluntary Capital Rationing

This paper compares three capital-budgeting rules, the NPV rule, a high hurdle rate and capital rationing, and explains why some firms may voluntarily impose capital rationing. Under both capital rationing and a high hurdle, a restrictive investment criterion is used to control managerial shirking. However, implementation of these budgeting rules requires a mechanism to prevent the firm from expanding the investment scale ex post. Capital rationing, in the form of a predetermined, fixed budget, differs from the high-hurdle-rate rule in that the former requires the firm to overcome the cost of raising additional capital before making further investment.