Capital Rationing

The firm may put a limit to the maximum amount that can be invested during a given period of time, such as a year. Such a firm is then said to be resorting to capital rationing. A firm with capital rationing constraints attempts to select the combination of investment projects that will be within the specified limits of investments to be made during a given period of time and at the same time provide greatest profitability.

Capital rationing may be effected through budget ceiling. A firm may resort to capital rationing when it follows the policy of financing investment proposals only by ploughing back its retained earnings. In that case, capital expenditure in a given period cannot exceed to amount of retained earnings available for reinvestment. Management may also introduce capital rationing when a department is authorized to make investments up to a limit beyond which investment decisions will be made by higher level management.

Capital rationing may result in accepting several small investment proposals then accepting a few large investment proposals so that there may be full utilization of budget ceiling. This may result in accepting relatively less profitable investment proposals if full utilization of budget is a primary consideration. Similarly, capital rationing also means that the firm foregoes the next most profitable investment falling after the budget ceiling even though it is estimated to yield a rate of return much higher than the required rate of return. Thus, capital rationing does not lead optimum results.