Capital Rationing Definition – Types of Capital Rationing

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Capital Rationing Definition and Types

Capital Rationing Definition – It refers to a situation which restricts or imposed restriction on Company to not to invest in all the investment projects having positive NPV.

In simple words, a company with itself has various investments projects. All these projects have positive NPV that means they are good for investing funds. But the question is do company need to invest in all the projects? Well here capital rationing comes which enable the firms to invest money logically and appropriately. So the concept of capital rationing helps the firms to identify the project or combination of projects which have the highest NPV within the available amounts of funds.

Types of Capital Rationing

To understand Capital rationing definition more better way, let’s have a look over Capital rationing. There are two types of Capital Rationing –

  • Internal Capital Rationing
  • External Capital Rationing

Internal Capital Rationing

It is a process where the restrictions are imposed  by the management. These restrictions could of various types. For example Management can limit the amount of fund to be invested by the divisional head or project head. It can also decide to not to borrow any fund for the additional funds required for completion of projects. Capital rationing internally can also be done if management decide a minimum rate of return required above the cost of capital from a project. Whatever the restrictions management choose to do capital rationing, firm has to forgo some of the profitable projects due to lack of funds.

Well capital rationing done internally also raises questions sometimes. But at the same time it is very important for the financial control. As firms have limited funds so it becomes very important to invest the funds carefully. Capital rationing play a very important role as it put a upper limit above which firms cannot exceed expenditure.

External Capital Rationing

This type of capital rationing occurs when there are imperfections in capital market. Imperfections in Capital market rises due to deficiency in market information or the attitude of the investors which could create hurdle in free flow of capital. Suppose there is a company by the name of BCA Ltd. It procures all the funds from Capital Market. However the firm has other funding opportunity also available such as bringing public issue. However the owner is not happy with the idea as it will dilute his ownership in the company.

Related Financial Terms of Capital Rationing

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