What is Capital Rationing?
Capital rationing has to do with the acquisition of new investments. More to the point, capital rationing is all about the acquisition of new investments based on such factors as the recent performance of other capital investments, the amount of disposable resources that are free to acquire a new asset, and the anticipated performance of the asset. In short, capital rationing is a strategy employed by companies to make investments based on the current relevant circumstances of the company. Generally, capital rationing is utilized as a means of putting a limit or cap on the portion of the existing budget that may be used in acquiring a new asset. As part of this process, the investor will also want to consider the use of a high cost of capital when thinking in terms of the outcome of the act of acquiring a particular asset. Obviously, any responsible company will choose to employ strategies that support the productive use of disposable funds built within a capital budget. At the same ti
When times are tough, many companies will ration capital – especially if times are tough and many projects within the company are competing for the limited about of capital that is available. Also capital rationing occurs when a there is a new project being introduced, companies will ration out how much of the budget will be given to each project. If in the past, a company had a return on investment that was lower than anticipated, they may want to implement a capital rationing strategy. For example, perhaps a company is handling more projects than they can handle as part of their overall expansion plan – they would consider that their cost of capital investment was 10% but because they have yet to complete any of their expansion plans, their actual return on investment decreases below the 10% level. In direct correlation to the negative cash flow, management opts to place spending restrictions on the number and cost of new projects for that fiscal year but raising the cost of capital
Capital Rationing occurs when a company has more amounts of capital budgeting projects with positive net present values than it has money to invest in them. Therefore, some projects that should be accepted are excluded because financial capital is limited. This is known as artificial constraint because the management may dictate the amount to be invested for project purposes. It is also the artificial constraints because the amount is not based on the product marginal analysis in which the return for each proposal is related to the cost of capital and projects with net present values are accepted.
