Every company maintains budget for different departments. This article deals with budget for investing in projects. The technique of capital budgeting is applied to select the best project giving a positive return over the time. But what happens when there are many good projects chosen by capital budgeting technique and budget for investment is limited.
Of course it is understandable for any company there is hardly so much cash available so as to sufficiently invest in all projects. So what does the company do in such situations?
It optimally uses the available fund for project investments. This also means that sometimes many a good project could not be selected because of limitation in the investment amount allocated. This process of deliberately restricting investments in new projects even after knowing the fact that the project can be a profitable one is called capital rationing.
The problem of capital rationing is said to exist in a company when it cannot or sometimes deliberately chooses not to invest in all value generating projects. But how is this accomplished? By following the rules of capital budgeting, but setting up a very high cost of capital for new investments, which as known earlier could not be achieved under the present conditions of the company.
Why do companies implement capital rationing? Usually because the recent or past performances of projects where investments have been made, is particularly low with below expected rate of returns on investment. For example Company X has invested in too many good projects with cost of capital as 8%. But these projects are now going slowly and are incomplete.
As a result Company X cannot put more investments in any new project, even though they may be profitable ones. So in order to keep itself from investing, Company X increases its cost of capital for new project investments as 15%. This under the circumstances cannot be achieved, hence giving Company X sufficient time for completing its existing projects.
What are the reasons for capital rationing? Reasons can be of two types internal and external. Internal reasons include management’s decision to curtail expansion plans, budgetary constraints put by seniors on departments, fear of losing control of the company by management if further debt is taken, non availability of human resources etc. External reason include company’s inability to get more debt from outside sources such as creditors or banks etc
Experts comment that capital rationing takes into consideration non financial reasons for halting good projects, which may include management politics. Such attitude destroys the value of a project and can affect the profitability of the company. Capital rationing hence can be compared to management’s failure in controlling the process & the budget.