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Capital rationing refers to the situation in which a company or organization sets a maximum limit on the amount of funds it will invest during a specific period. This could occur due to various factors, such as a shortage of available capital, the need to prioritize projects due to limited resources, or a strategic decision to focus on certain investment opportunities. By establishing a cap on investment funds, management must carefully evaluate potential projects to ensure that the limited resources are allocated to the most beneficial or promising initiatives.

The rationale behind this approach is to optimize the use of available funds while maximizing returns. This process may involve ranking projects based on criteria such as internal rates of return, net present value, or alignment with company strategy, and selecting only those that fit within the established budget constraints.

In contrast, situations that involve limiting investments in unprofitable projects do not explicitly address the broader context of setting a maximum investment cap. Having unlimited funds for investment contradicts the fundamental concept of capital rationing, which is centered around the limitation of available resources. Lastly, while investing only in projects with high external rates of return is a sound investment strategy, it is not the defining characteristic of capital rationing.