How does Capital Rationing help Capital Budgeting?

Financial decision-making is one of the most integral parts of the overall business management of a company. The decisions made by a financial department of a company have to be under the framework of overall corporate objectives and policies. A finance department cannot take decisions that are not in sync with the corporate policies of a business concern.

The decisions in financial management have been categorized into three parts −

  • Investment decisions

  • Financial Decisions

  • Dividend decisions

The investment decisions are related to assets in which the company will invest its funds. The assets that can be acquired within investment decisions are broadly divided into two categories −

  • Long-term assets, and

  • Short-term assets

The decisions regarding short-term assets are known as working capital management and the decisions that are taken with a long-term view are known as capital budgeting.

Capital Budgeting

Capital budgeting is the long-term decisions making process of a firm and it is the most critical decision-making process for a business concern. As the process of long-term decision-making is the backbone of a company, it is considered one of the most crucial aspects of decision-making by a firm.

  • Capital budgeting relates to the selection of an investment proposal or an asset the benefit of which will be available in the longer time or lifetime of the asset.

  • Capital budgeting is the process of making long-term business decisions that will help it to acquire assets over a fixed period. Capital expenditures show the effects over a longer tenure and capital budgeting helps the acquisition of fixed assets over a longer term of the business decision-making process. These expenditures are related to the acquisition and replacement of fixed assets.

Capital Rationing Decisions

Capital rationing is a capital budgeting decision that limits the number of options a business can invest in by shortlisting the options according to their profitability. In such a case, there is more than one option that is viable, but the funds are limited. The company may have limited funds in its possession and so deciding to invest in the best fund is probable.

  • The capital rationing method is one of the most crucial decision-making processes a business may need to take. It helps the capital budgeting process by taking into consideration the returns of investment from different projects.

  • Capital rationing offers an idea of the best investment for a firm in the long term and hence it is an integral part of the capital budgeting process.

  • Capital rationing ranks the projects in descending order of their profitability, making it easier to take a business or investment decision without any hassle.