When times are tough, many companies will ration capital – especially if times are tough and many projects within the company are competing for the limited about of capital that is available. Also capital rationing occurs when a there is a new project being introduced, companies will ration out how much of the budget will be given to each project.
If in the past, a company had a return on investment that was lower than anticipated, they may want to implement a capital rationing strategy. For example, perhaps a company is handling more projects than they can handle as part of their overall expansion plan – they would consider that their cost of capital investment was 10% but because they have yet to complete any of their expansion plans, their actual return on investment decreases below the 10% level. In direct correlation to the negative cash flow, management opts to place spending restrictions on the number and cost of new projects for that fiscal year but raising the cost of capital to 20%. That will buy the company more time to finish off the expansion projects that have already begun.
Capital rationing sets limits for a company’s investment strategy, forcing a company to seriously evaluate all the projects they are interested in pursuing and making the best decisions for a return on investment. By instituting a policy of capital rationing a company can help ensure that there is available money needed to handle their basic operating costs and maintain the balance of their business.
When a company is considering capping their investments with a capital rationing strategy they need to lay down a business plan and fully evaluate some key factors. The corporate heads should ask themselves “how financially stable and liquid is the company,” “what are the company’s plans, both long term and short term,” and finally “how much can the company afford to invest while still maintaining the quality of our operating ability.”