What is Capital Rationing?
Capital rationing is a financial management approach that is used by companies to distribute the available capital or funds among various investment projects. Through this, the company wisely allocates its funds to projects that will improve the company’s overall profitability and have a greater return potential. Companies try to invest in projects that provide the highest overall net present value (NPV).
The primary objective of capital rationing is to maximize the return on investment, focus on long-term growth, and prevent the company from investing too much in assets that will deliver lower returns due to which the company can face financial; insolvency.
Types of Capital Rationing
Hard Capital Rationing:
- This happens when a company faces external limitations on raising funds through debt or equity.
- The company cannot access additional capital due to factors outside its control, such as unfavorable market conditions, high interest rates, or strict lending conditions imposed by financial institutions.
- It is rigid and less flexible because it is driven by external market forces or economic conditions.
- Reduced expenses may lead to a shortage of capital for future projects.
Soft Capital Rationing:
- This occurs when a company imposes internal restrictions on capital expenditures, often due to managerial decisions or budget constraints, rather than external factors.
- Also known as internal rationing, soft capital rationing occurs due to a company’s internal policies.
- A financially conservative organization, for instance, may set a high required return on capital for future projects, leading to self-imposed capital constraints.
- These internal constraints are more flexible and can be adjusted based on changing priorities or circumstances. The company has control over these limits and can modify them as needed.
Benefits of Capital Rationing
- Forces a company to prioritize projects, ensuring that capital is invested in the most valuable and strategic opportunities that will give favorable returns.
- Helps avoid overextension of resources. This will reduce the risk of financial strain and maintain a profitable balance sheet.
- Ensures that limited capital is directed towards projects with the highest potential returns, making overall investment performance better.
- Promotes more efficient use of available funds by eliminating less profitable or lower-priority investments.
