Capital Rationing

To provide capital for the anticipated well-reasoned and well-investigated projects (or investment opportunities) is a very important and necessary process. Considering in this way, such an exercise is called Capital budgeting in several contexts. However, there always are quite a few p~ojects  in the proposal stage whose aggregated demands for capital expenditure generally exceed the supply of capital, particularly if there is a budget ceiling, or constraint, on the amount of funds available that can be invested during a specifiedperiod, say, a year. Besides this constraint on the supply side of funds, there is also a large range of variation in the prospective returns, demand by demand, covering a wide range. And yet a third consideration comes into picture as regards the cost of capital which usually increases with the total quantum of capital; and to make profits, the firm is obliged to look into only such projects which can yield at least a little more than the cost of capital. Such a yield rate is called thz cut-off rate or the hurdle rate. Constraints on the total available supply of capital impact highly if the firm adopts a policy of financing much of the demanded capital expenditure from internal sources, possibly with a view to contain the cost of capital. Also, particular divisions of a large firm may be subjected to specified budget ceilings. 

In such circumstances, 

• it is not only important that none of the limited capital be appropriated to aggressive (i.e. high magnitude) demands, particularly if they may yield rates of return less than the hurdle rate (and worse still if the yield is less than the cost of capital), but
• it is also important that the limited funds be given only to the very best investments. 

Hence, such an exercise of allocation of funds among the basket of investment opportunities available is better called capital rationing. 

Accordingly, capital rationing, also called capital budgeting in certain contexts, is an organised procedure for investigating and quantifying the input and output parameters of alternatives, evaluating each alternative, (listing or) laddering all the alternatives in the order of their merits, separately also determining the sources of capital and their costs, and then appropriating the supply to the best of the demands so as to maximise' the shareholders' wealth (through maximisation of the total NPV).