What is Capital Rationing?

Capital rationing is the decision process used to select capital projects when there is a limited amount of funding available. This can occur when a business is unable to obtaining funding from outside sources at a reasonable price, or when management decides to allocate available funds to other purposes, such as the payment of dividends to investors. Rationing may also be imposed when there is enough funding, but management is restricting it from certain parts of the business in order to emphasize investments in other areas. There are a number of ways to engage in capital rationing, including the following:

Focus on highest returns. Management could allocate funding just to those areas most likely to generate the highest returns. A variation is to apply a higher cost of capital to net present value calculations to strip away lower-return projects. This approach improves short-term profits, but may not enhance profits over the long-term, since it ignores strategic changes that may require long-term investments.
Focus on strategy. Management could channel funding toward strategically important areas. Doing so provides good long-term competitive positioning for the business, but possibly at the cost of a short-term decline in profits.
Focus on throughput. Management could focus funding on bottleneck operations to enhance throughput. Doing so increases the capacity of the bottleneck operation, making it easier to meet order commitments made to customers. A beneficial side-effect of this approach is that the business will then spin off more cash, which may subsequently ease the capital rationing situation.