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It is the strategy used by firms to identify the most profitable projects from the proposed future plans to invest.
Since companies work with restricted funds, they need to find out projects that are more beneficial in comparison to others as compared to the capital available.
The basic assumption made is that all firms need to have restriction on expenses and the method adopted for all the internal financing of the budget restrictions, limit investments on certain projects.
The method of capital rationing can be adopted to compare the ROI of proposed projects where they may use mathematical calculations like integer, goal /linear programming to assess the situation.
There are many methods of such– the first is that it introduces a sense of strict budgeting of the resources at the point of the injunction of capital – in the form of borrowing or stock issuance capital. It can be properly handled or invested in
It also lowers wastages as the firm invests money and time on the minimum number of active projects and manages it well.
The method also provides insight into the most wasteful projects that can be eliminated from the scheme.
When the firm provides financial services to the limited number of projects, it is able to put funds aside for a tough time and it increases stability and stock values.
There can be two types of rationing – hard capital rationing where the company faces problems in raising funds in the external equity markets.
It leads to a shortage of capital to finance new projects. The method is adopted by start-up firms due to restrictions on spending, or it can be adopted by companies due to the industry’s specific factors or lender restrictions.
Soft capital rationing could be adopted for internal policies where the firm voluntarily adopts certain restrictions that limit the number of available funds to be invested in other ventures.
The reason to adopt it is that it increases the opportunity cost of capital useful for future scenarios. The firm may take the decision to adopt soft capital due to promoters’ pressure, who may assume a drop in the interest rate in the future and they may want to make less expensive financing.
There are certain drawbacks of the methods like it can lead to higher capital requirement situations at one time and it may expose the investors to higher risk factors due to failure to diversify through an alternative investment strategy and may not be able to meet up the efficient capital markets theory.
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