Purpose, Strength and Weakness of Capital Rationing

Paseda (2017) points out that the main purpose of this practice is aiding the management of a firm to put restrictions on the projects that a firm should undertake, or putting restrictions on amount of funds that a firm can invest. As a consequence, a firm will only seek and invest on the projects it deem most profitable. Against this background, some of this practice strength and weakness will be highlighted.

To start with, the practice fosters a sense of very strict budgeting and as such reduces the chances of wastage and misappropriation of a company’s resources which may arise from undertaking every new project available (Klara, 2016). Relatedly, it ensures that few projects are undertaken and thus are well managed which in turn ensures that the undertaken projects yield higher returns. Nonetheless, the practice has some weaknesses. Firstly, Umair (2015) elucidates that it violates the theory of efficient capital markets which states that each and every project that increases a company’s value and investor’s wealth should be undertaken. Secondly, apart from putting limits on amount to be invested, the practice adopts a selective process to determine cost of capital of the projects to be undertaken. However, in order for the practice to be successful, a firm has to be accurate in determining capital cost since any error would direct it to undertake a project that is less profitable (Bartram et al., 2015).