Capital rationing may be effected through budget ceiling. A firm may resort to capital rationing when it follows the policy of financing investment proposals only by ploughing back its retained earnings. In that case, capital expenditure in a given period cannot exceed to amount of retained earnings available for reinvestment. Management may also introduce capital rationing when a department is authorized to make investments up to a limit beyond which investment decisions will be made by higher level management.
Capital rationing may result in accepting several small investment proposals then accepting a few large investment proposals so that there may be full utilization of budget ceiling. This may result in accepting relatively less profitable investment proposals if full utilization of budget is a primary consideration. Similarly, capital rationing also means that the firm foregoes the next most profitable investment falling after the budget ceiling even though it is estimated to yield a rate of return much higher than the required rate of return. Thus, capital rationing does not lead optimum results.