Advantages and Disadvantages of Capital Rationing

Capital rationing refers to an approach used to limit the number of projects that a company or an investor should take on at any particular time. Usually there are numerous alternative investments that a company can implement to generate income; but the company cannot invest in all of them due to the scarcity of resources. Capital rationing helps the business to choose the most profitable investments and allocate the required amount of capital. Capital rationing is important for any company because it helps the company to put their money in the most profitable projects. A company that uses capital rationing will earn a higher return on investment (ROI) because it is able to invest their resources in areas that have the potential of generating the highest profits or returns.

Capital rationing is important for any business because it ensures that the firm chooses only the most feasible investments. It allows the company to invest only on those projects that have potentially high returns. However, even when there are promises of high returns an investor may want to prefer current cash flows over investments.

Advantages

  • Limited Number of Projects are Easier to Manage

Companies can use capital rationing to limit the number of projects to invest in order to make it easier to manage the chosen projects. A large number of projects may be difficult to manage simultaneously. Sharing funds and human resources among multiple projects cause a strain on the company’s resources and finances.

  • Increased Flexibility

Capital rationing gives the company the flexibility it needs to adjust to changing circumstances in the business environment. By limiting the amount of cash used in funding investment projects, the company ensures that it has enough cash flows to achieve stability and meet emerging financial obligations. Keeping a reserve of cash also enables the firm to take advantage of lucrative opportunities whenever they emerge.

Disadvantages

  • High Capital Requirements

A company that has little funds does not have the luxury to do capital rationing. Capital rationing may sometimes require a large amount of capital to invest in the most lucrative investments.

  • Goes against the efficient capital markets theory

Capital rationing allows companies to select a few projects with potentially high returns instead of investing in all projects that offer good returns. However, the efficient capital market theory suggests that it is virtually impossible to continually select superior projects that significantly outperform others. It also exposes the company to higher risks because it does not allow them to hold a diversified investment portfolio.

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