What is capital rationing with example?
Capital Rationing:
Capital rationing refers to the situation where a company faces constraints or limitations on the amount of funds available for investment in capital projects or opportunities. In other words, the company has a limited budget for capital expenditures, and it cannot undertake all the projects that may be financially viable.
Key Points:
Limited Resources:
Capital rationing arises when a company has limited financial resources, preventing it from investing in all potentially profitable projects.
Strategic Decision:
It is a strategic decision-making process where the company must prioritize and allocate its limited capital to the most promising projects that align with its overall objectives.
Various Reasons:
Capital rationing may occur for various reasons, such as tight financial constraints, conservative financial policies, or the desire to maintain a certain level of liquidity.
Risk Management:
It can be a way for companies to manage risk by avoiding over-leverage or over committing funds to projects that may carry uncertainties.
Evaluation Criteria:
Companies under capital rationing often use specific evaluation criteria, such as the profitability index or the internal rate of return, to select projects that offer the highest return per unit of investment.
Example:
Imagine a company that has identified several potential projects for expansion but has a limited budget for capital expenditures. The company may engage in capital rationing to determine which projects to prioritize based on their expected returns, payback periods, or other financial metrics. Projects that offer the highest return on investment within the budget constraints would be selected, while others may be deferred or rejected.
In finally,
Capital rationing requires careful analysis and decision-making to ensure that the limited capital is allocated to projects that contribute most effectively to the company's growth and profitability.