What is Capital Rationing? What is the normal procedure followed for Capital Rationing?

What is Capital Rationing? What is the normal procedure followed for Capital Rationing?

Capital Rationing is the business decision which is used to place restriction on the amount available to spend on new investments or projects. It restricts the channels of outflow of funds by restricting the number of new projects. Small projects are better manageable by the companies and related to the specific sections of budget.

The procedure which is adopted is that companies implement capital rationing in situations where past returns of investment were lower than expected. For example, suppose a company has a cost of capital of 15% but that the company has taken too many projects in their hands, out of which many are not finished. These incomplete projects cause the company's a drop in actual return on investment. Due to this reason, management decides to place a restriction on the number of new projects by raising the cost of capital for these new projects to such an extent so that company will not invest on large number of new projects. Starting with few new projects would give the company more resources to complete unfinished or existing projects.

What "other" factors are taken into consideration while practicing capital rationing?

The factors that are influencing capital rationing decisions include both financial situations and management philosophy. Companies can limit capital spending by seeing the effect of NPV (net present value) or IRR (internal rate of return) on the overall budget amount. Other factors which are taken into consideration includes amount of funds that come from current operations and feasibility of acquiring capital.