Plain definition
Capital rationing occurs when a company has a fixed limit on the capital it can deploy, so it cannot accept every project with positive NPV. The constraint may be hard, such as unavailable external finance or a covenant limit, or soft, such as a temporary management-capacity limit. The decision becomes a portfolio problem: which feasible combination creates the most value while respecting cash timing, risk, dependencies, and execution capacity?
Ranking projects one at a time is not enough. A high-return small project may fit alongside another project; a large project may prevent both. Projects can also be indivisible, mutually exclusive, or dependent on the same people and suppliers. The constraint and the dates at which cash is needed must be explicit.
Illustrative example
Monetary examples use Saudi riyals (SAR). The same principles apply in other currencies.
Suppose the investment budget is . Project A needs and has NPV of . Project B needs and has NPV of . Project C needs the full and has NPV of . Selecting A and B uses the whole budget and creates of NPV, which exceeds C’s even though C may be a single visible proposal.
The answer can change if A and B need the same installation team, if one must be done first, or if their cash outlays occur before funding is available. Capital rationing therefore joins finance arithmetic with operating reality.
| Project A NPV | |
|---|---|
| Project B NPV | |
| Combined NPV of A and B |
A stated annual budget can conceal a monthly funding shortfall. Test the actual drawdown dates, not only the total committed amount.
Why it matters
When capital is scarce, approving each positive project independently can produce an impossible plan. Explicit rationing makes the trade-offs reviewable and prevents an attractive project from consuming the option to fund a better combination.
Practical consequence
List all candidate projects with dated cash needs, NPV at consistent assumptions, main dependencies, and whether they can be split or combined. Define the true constraint and construct feasible combinations rather than a single ranking. Compare total NPV, cash headroom, concentration of risk, and execution capacity, then document which rejected projects should be reconsidered if the constraint changes.