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# Capital Rationing

What Does Capital Rationing Mean? The act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on the specific sections of the budget.

Investopedia explains Capital Rationing Companies may want to implement capital rationing in situations where past returns of investment were lower than expected. For example, suppose ABC Corp. has a cost of capital of 10% but that the company has undertaken too many projects, many of which are incomplete. This causes the company's actual return on investment to drop well below the 10% level. As a result, management decides to place a cap on the number of new projects by raising the cost of capital for these new projects to 15%. Starting fewer new projects would give the company more time and resources to complete existing projects. Read more: http://www.investopedia.com/terms/c/capitalrationing.asp#ixzz1addWe4hS
capital rationing The placement of restrictions on the quantity of new investments or projects that a company will undertake. Capital rationing is executed through the imposition of a higher cost of capital for investment or the establishment of a ceiling on specific sections of the budget. This decision implies that the costs of raising new capital are prohibitively high with respect to expected returns, creating a situation where capital investment opportunities must compete for funds. Capital rationing may be prompted by past investments that yielded lower returns than expected. This may happen, for example, if a company is involved in too many projects at once leaving most of them too incomplete to yield a substantial profit. In such a case capital rationing may facilitate the maximization of existing projects. Capital rationing is technique which is used with capital budgeting techniques. Capital rationing technique is used when company has limited fund for investing in profitable investment proposals. In other words Capital rationing is a strategy employed by companies to make investments based on the current relevant circumstances of the company. Explanation of Capital Rationing With Simple Example For example, Company fixes his priority to invest his money in more profitable projects. Suppose a company has \$ 1 million dollar and after using the Profitability index technique of capital budgeting company found that three projects of \$ 600000, \$ 300000 and \$ 400000 are profitable out of seven projects but if company has limited cash of \$ 1 million only. With this money, company can use capital

rationing technique. Under this technique, if company sees that First and third proposal s profitability index is high than second, then they will select only two projects combination out of three projects. Read also second example of capital rationing.

## >> April 10, 2010

One of my UK student wants to know the capital rationing with simple example. before studying the example, please read following introduction of capital rationing. Capital rationing exists when investor is interested to invest his limited fund in most profitable investment proposal. In this case, a firm may be confronted with more desirable projects than it is willing to finance. Now, We can explain capital rationing more deeply with following simple example: Capital Rationing: An Example: (Firm s Cost of Capital = 12%) Independent projects ranked according to their IRRs: Project Project Size E \$20,000 B 25,000 G 25,000 H 10,000 D 25,000 A 15,000 F 15,000 C 30,000 21.0% 19.0 18.0 17.5 16.5 14.0 11.0 10.0 IRR

No Capital Rationing - Only projects F and C would be rejected. The firm s capital budget would be \$120,000. Existence of Capital Rationing - Suppose the capital budget is constrained to be \$80,000. Using the IRR criterion, only projects E, B, G, and H, would be accepted, even though projects D and A's IRR is higher than our cost of capital but we can not include because of our capital budget is limited upto \$ 80000. {*Also note, however, that a theoretical optimum could be reached only be evaluating all possible combinations of projects in order to determine the portfolio of projects with the highest NPV.}

capital rationing
Definition
Limiting a company's new investments, either by setting a cap on parts of the capital budget or by using a higher cost of capital when weighing the merits of potential investments. This might happen when a company has not enjoyed good returns from investments in the recent past. Capital rationing also could take place if a company has excess production capacity on hand.

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## Corporate finance and investments Intensive revision course www.riskmatrix.EU

Since capital rationing is all about setting criteria that any investment opportunity must meet before the company will seriously entertain the purchase, many businesses choose this strategy as their guiding process for any acquisitions. Using the basic principles of the technique, a company can develop a list of standards that must be addressed before any capital purchase. If the standards are drafted in a manner that accurately reflects the current condition of the company, then there is a good chance the right types of investments will be considered. Some of the more important factors to consider as part of a productive capital rationing approach are the financial condition of the company, the long and short term goals of the business, and proper attention to daily operations. One of the benefits of capital rationing is that the approach helps to ensure that funds for basic operations are not diverted in order to take advantage of a socalled cant fail opportunity, which helps to maintain the stability of the business.

capital rationing
Definition
Management's approach to allocating available funds among competing investment proposals; only the proposals that maximize the total net present value (NPV) of the investment are selected. Ads by Google

vvcapital rationing
Definition
Management's approach to allocating available funds among competing investment proposals; only the proposals that maximize the total net present value (NPV) of the investment are selected. Ads by Google

## What is Capital Rationing

Capital Rationing in simple words refers to a situation where an organization cannot undertake all the projects which are having positive net present value because of shortage of capital. When company do capital rationing than it will select only that project which gives the company maximum profit.

Capital rationing can be better understood with the help of an example suppose you are having \$100 and you go to a restaurant where pizza and burger both cost \$100 and you are hungry and can eat both if you are given an option but since you have only \$100 you will have to choose either pizza or burger. In the same way if a company has limited capital than it cannot take all the projects but only select those projects which it can afford with the limited amount of capital. Companies go for capital rationing when they are not able to raise fresh capital from the markets because of external factors like slowdown in an economy, higher interest rate environment etc, or due to internal factors like excessive debt in the balance sheet of the company, no further issue of equity capital so as to prevent dilution of control of existing shareholders of the company etc