Reviewed by Sep 28, 2020| Updated on
Capital rationing is defined as the process of placing a limit on the extent of new projects or investments that a company decides to undertake. This is made possible by placing a much higher cost of capital for the consideration of the investments or by placing a ceiling on a particular proportion of a budget.
A company might intend to implement capital rationing in scenarios where the past revenues generated through investments were not up to the mark.
Understanding Capital Rationing
Capital rationing is necessarily an approach of management in allocating the funds available across various opportunities of investment, thereby enhancing the bottom line of the company. The company will go on to accept the blend of projects that have the net present value (NPV) on the higher side.
The primary intention of the capital rationing is to make sure that a company is not going to invest heavily in assets. With insufficient rationing, a company may go on to witness the returns provided by their investments going on the lower side and may even reach a scenario where the company enters the stage of financial insolvency.
Types of Rationing
The first type of capital rationing is called as the hard capital rationing. This type of rationing happens if a company is having issues with raising excessive funds, either by means of debt or equity. The rationing happens from an external dependence in order to cut down on expenses and may result in the shortage of capital to raise enough money for projects in future.
The second kind of capital, rationing, is referred to as the soft capital rationing. It is also called as the internal rationing. This happens because of the internal policies of an organisation. A company that is financially conservative will have a high required return on the capital invested in taking up projects in the coming days, thereby imposing self capital rationing.