Capital Rationing | Types, Benefits & Limitations
Uses of Capital Rationing:
Optimal Resource Allocation:
Capital rationing helps in optimal resource allocation by prioritizing and selecting projects that offer the highest returns within the limited budget. This ensures that the available funds are used efficiently.
Risk Management:
It serves as a risk management tool by preventing over commitment of resources to projects. Capital rationing helps avoid situations where a company takes on excessive financial risk by undertaking too many projects simultaneously.
Maintaining Liquidity:
Capital rationing allows companies to maintain a certain level of liquidity and financial flexibility. By limiting the amount of capital invested in projects, a company can ensure it has sufficient funds for unforeseen expenses or opportunities.
Strategic Decision-Making:
It forces companies to make strategic decisions about which projects align best with their long-term goals and objectives. This can lead to a more focused and disciplined approach to investment decisions.
Avoiding Over leveraging:
Capital rationing prevents companies from becoming overly leveraged or taking on too much debt to finance projects. This can contribute to financial stability and reduce the risk of financial distress. Limitations of Capital Rationing:
Missed Opportunities:
One of the main limitations is that capital rationing may result in missed investment opportunities. Some projects with high long-term potential may be deferred or rejected due to budget constraints.
Inefficient Use of Resources:
It may lead to an inefficient use of resources if the available budget is not sufficient to fund projects that, when combined, could generate synergies or additional value.
Impact on Growth:
Capital rationing can potentially limit a company's growth prospects, especially if there are valuable projects that cannot be undertaken due to budget constraints.
Focus on Short-Term Returns:
Companies under capital rationing may prioritize projects with quick payback periods or short-term returns, neglecting projects with longer gestation periods that could bring substantial benefits in the future.
Difficulty in Comparison:
Comparing and prioritizing projects under capital rationing can be challenging, as the traditional methods of comparing projects based on their net present value (NPV) or internal rate of return (IRR) may not provide a clear decision criterion. In summary, while capital rationing helps in efficient resource allocation and risk management, it also has limitations related to missed opportunities, potential inefficiencies, and challenges in decision-making. It requires careful consideration and strategic planning to balance the benefits and drawbacks.