What is Capital Rationing?

Example of Capital Rationing

Let us take an example to understand the concept better.

Suppose there is a company named Yuva Constructions Ltd (‘YCL’). YCL is engaged in the business of construction of buildings for residential and commercial purposes. It has secured the required preliminary permissions and approvals from the state government for constructing three projects – Project A, B, and C.

YCL has a total budget of $10 billion. Project A, B, and C are expected to yield total value (present value of cash flows) of $7 billion, $8 billion, and $6 billion respectively viz a viz the initial investment required for each is $5 billion, $6 billion and $5 billion respectively. Apply the capital rationing and find the optimal combination.

Solution:

First, let’s tabulate the information provided to us for ease of reference.

  • Now, YCL has $10 billion. To maximize the investors’ wealth, it will have to accept projects to receive the highest amount of profits within the limited budget of $10 million. Accordingly, it will have to find out the expected rate of return for all the projects and then rank them according to profitability indexProfitability IndexThe profitability index shows the relationship between the company projects future cash flows and initial investment by calculating the ratio and analyzing the project viability. One plus dividing the present value of cash flows by initial investment is estimated. It is also known as the profit investment ratio as it analyses the project’s profit.read more.

The below table thoroughly explains the same.

  • Based on the ranks, YCL must select Project A and B, as they have the highest profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more. However, the total initial investment required if it chooses Project A and B would exceed the available funding, i.e., it will require $11 billion ($5 billion + $6 billion) compared to the available $10 billion.In such a situation, it will have to discard one project and move to the next ranking project which suits its investment needs. Thus, YCL will have the option to go ahead with Project A and C, which will entail an investment well within the available capital of $10 billion and will have to forego investing in Project B.

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Types

It can be segregated based on two types. The first is known as hard rationing, and others are referred to as soft rationing.

  • Hard Capital Rationing means when the additional capital infusion or any restriction on the use of existing investment funding is limited by forces of external sources.Soft Capital Rationing refers to restrictions on the use of capital funding for various projects based on restrictions imposed by management and its decisions.

Assumptions

Some of the assumptions are as follows.

  • The primary assumption is that there is a restriction imposed, either through internal forces or external, on capital funding.The other assumption followed here is that there are several projects to be undertaken by the company or investors. Selecting certain projects will help optimize returns for the investment made.Lastly, the concept of capital rationing is based on the assumption that the expected rate of return of proposed projects to be undertaken shall be achieved as expected, thus ignoring practical factors such as economics, politics, policies, and such.

Causes

  • The increased cost of capital for higher capital/funding requirements.Higher debt in books of the company.Any internal management restriction.Lack of human resources or knowledge for undertaking all the projects.

Capital Rationing vs Unlimited Funds

Benefits

The use of capital rationing does come with its shares of advantages and benefits for the users. Some of the benefits are as follows.

  • Any restriction on the use of available resources, in our case money, will utilize the resource in the best optimal manner.The company’s management or investors would not invest in any project coming their way without getting into detailed analysis. This ensures there is no wastage or unnecessary use of free funds available.The investors would receive the highest or maximum returns on their investments by following the optimal utilization process.It may entail investing in only a few projects, which would help the management put in lesser efforts in managing the affairs of the projects and yield better results.The company or the investor will have funds available even after investing in the projects, thus ensuring there is no cash crunch.

Limitations

Some of the limitations are as follows.

  • It focuses on investing in fewer projects, which keeps the balance shareholder funds idle.The concept of capital rationing is based on the assumption that the project will yield a particular return. Any miscalculation of the same would result in the project generating lesser profits.Projects that are selected may be of smaller duration, which would lead to discarding certain long-term projects, which may be healthy for the company’s stability.The evaluation process ignores any intermediate cash flows that the project may have and the time value associated with such cash flows.

Conclusion

Capital rationing is a process of selecting a project mix that will provide the maximum profit by investing the limited capital available in various projects. The process is followed after considering the restrictions in place, whether internal or external forces, for the investments to be made.

This has been a guide to what is Capital Rationing and its meaning. Here we discuss an example and two types (Hard and soft rationing) of capital rationing with their assumptions, causes, and differences. You may refer to the following articles to learn more about finance –

  • Capitalization CostCapital StockCapital OutlayCorporation Examples