Question

Why is the practice of capital rationing quite common? After reading the introduction to this section in the textbook, my initial thought matched the question the book asked next: "Why would any company forgo value-adding projects". The book then lists several reasons why a company may do this, but I am having trouble understanding some of these reasons, which leads me back to my original question asked here.

Answer 1

The practice of capital rationing is quite common because it will help to place restriction, in the use of fund by placing of certain standard in acceptance of the projects, even if the projects are yielding the positive returns to the company.

Capital rationing is a technique through which the firm will determine certain restrictions in order to accept various project even if those projects are having an acceptable criteria through various techniques like net present value and internal rate of return and payback period or profitability index.

This is such because the capital rationing process advocates that the money should only be allocated to those products which are best suitable for the overall maximization of the value of the firm and it should not be allocated to each of the project because there would be certain better projects which could be lined up in the future, so the money should be properly allocated after redefining a certain standard while allocation of money to different projects so the capital rationing is a process of selection of the best possible projects in order of placement of various restrictions to maximize the overall value of the company.