What is Capital Rationing?
Capital Rationing refers to the approach of limiting the scope of new investments that a corporation wants to pursue. This can be accomplished by imposing a slightly higher cost of capital for the investment decision or a price ceiling on some portion of the budget.
Understanding of Capital Rationing
Rationing is basically the procedure of restricting the localization or consumption of a good or service in response to insufficiency. Capital rationing is a way of managing the allocation of available cash across various investment options in order to boost a firm's bottom line.
The corporation will accept the project selection with the largest average Net Present Value (NPV). The primary purpose of this type of rationing is to prevent an organization from overinvesting in assets. Without sufficient rationing, a firm's rate of return may begin to decline and it may even risk a financial situation.
Types of Capital Rationing
Generally, it can be divided into two categories -
- Hard capital rationing happens in times of difficulty raising new capital in businesses. Rationing comes out of a need to cut expenses from outside sources, and it may result in financial difficulties to fund new investments.
- Soft capital rationing can be caused because of an organization's corporate policies. For example, an economically responsible company may impose its own rationing by requiring a high necessary cash flow to approve a project.
Practical Example
Hk Corp. seems to have a 9% cost of capital, but the corporation has taken on too many unfinished projects. As a result, the firm‘s rate of return falls significantly below the 9% mark. Therefore, management chooses to limit the number of new initiatives by increasing the cost of capital by 14% for these operations. Launching more new initiatives would free up time and resources for the firms to finish their existing projects.
In Sentences
- The term capital rationing is basically a financial term used by different corporations or companies that indicates the decision to limit new investments.