What is the main purpose of capital rationing in project selection?

Capital rationing refers to the process of limiting the amount of capital that a firm can allocate to different projects, often due to budget constraints. The main purpose of capital rationing is to ensure that the company invests in only the most promising projects, thus optimizing the return on investments.

Choosing to limit investments to only the best projects based on the internal rate of return (IRR) aligns with the concept of capital rationing because IRR is a metric used to evaluate the profitability of potential investments. When a firm faces capital constraints, it will prioritize projects that offer the highest IRR to ensure that the limited resources are used effectively, resulting in improved overall performance and value creation for the company.

While maximizing net present value (NPV) is typically a goal of investment analysis, the constraints imposed by capital rationing make it essential to focus on projects with the best returns relative to their costs (often assessed through IRR). Therefore, limiting investments to projects with the highest IRR is a strategic approach to ensure optimal allocation of scarce resources.