What is capital rationing?
Capital rationing involves a company limiting its investments to select profitable projects, thus managing its funds effectively. It's a strategic approach to avoid over-investment and maximize the net present value (NPV) of investments.
Understanding Capital Rationing
Capital rationing is a decision-making process in which companies select the most profitable projects to invest in, considering their limited funds. The focus is to maximize the net present value (NPV). It may also involve investing in long-term projects that align with the company's future goals, even if this implies sacrificing immediate profit.
Types of Capital Rationing
Capital rationing can be divided into hard and soft types.
Hard capital rationing occurs due to external constraints such as difficulty in raising funds or restrictions imposed by creditors, limiting the company's investment abilities.
Soft capital rationing, also known as internal rationing, is when a company imposes its own restrictions on capital usage. For instance, a highly cautious company might demand high returns before investing, thus limiting its capital expenditures.