Capital Rationing

In theory, a company should invest in every project that is expected to earn more than its cost of capital. In practice, companies often face limits. These may come from outside, such as difficulty raising funds, or be set internally, such as a fixed capital budget, a desire to avoid more debt or limited management capacity.

When capital is rationed, the company needs to choose the combination of projects that creates the most value within its budget.

For example, a company has a budget of 10 million and three projects: A costs 6 million and has a net present value of 1.5 million, B costs 4 million with an NPV of 1.2 million, and C costs 5 million with an NPV of 1.4 million. Choosing A and B uses the full budget and gives a combined NPV of 2.7 million, more than any other combination that fits.

The profitability index, which compares a project's present value with its cost, is often used to rank projects under capital rationing.

Capital rationing can mean passing up valuable opportunities, so companies facing persistent limits may consider ways to raise additional funding.