What is capital rationing?
Capital rationing is managing a company's available funds by choosing the most profitable projects to invest in. This means that the company sets a limit on how much it can spend on new projects or investments, either by using a high cost of capital or by setting a budget constraint. Capital rationing helps the company to avoid investing too much in assets that may not generate enough returns. The company uses capital rationing to maximize its investments' net present value (NPV).
Understanding Capital Rationing
Capital rationing is choosing the best projects or investments for a company with limited funds. The main goal is to get the most return on their money. A company will usually try to use its money for projects that have the highest total net present value (NPV).
Companies may also use capital rationing to invest in projects with more long-term benefits for the business and its future goals. This may mean giving up some immediate profit.
Types of Capital Rationing
There are two main kinds of capital rationing: hard and soft.
Hard capital rationing happens when a company faces external constraints on its capital. For example, the company may have trouble raising more money from equity or debt sources. Or, its creditors may impose restrictions on how it can use its capital. These situations will limit the company’s ability to invest in new projects and may even force it to cut spending on existing ones.
Soft capital rationing, or internal rationing, happens when a company sets its own policies on how it wants to use its capital. A very cautious company, for example, may demand a very high expected return on its capital before investing in a project—effectively limiting its own capital spending.