Capital Rationing

Capital rationing is a technique of selecting the projects that maximize the firm’s value when the capital infusion is restricted. Two types of capital rationing are soft and hard capital rationing. The calculation and method prescribe arranging projects in descending order of their profitability based on IRR, NPV, and PI and selecting the optimal combination.

Many times, a firm may come across a situation when it has various profitable investment proposals. Can it take all of them for execution? Not always because most of the time there are capital restrictions. This restriction maybe because of the investment policy of the firm and at the same time, it is not possible to acquire unlimited capital at one cost of capital. In such a situation, the finance manager would accept a combination of those projects, totaling less than the capital ceiling, to achieve the maximization of wealth. This process of evaluation and selection of a project is called capital rationing.

Definition of Capital Rationing

It can be defined as a process of distributing available capital among the various investment proposals in such a manner that the firm achieves a maximum increase in its value.

Capital Rationing

Capital RationingTypes of Capital Rationing

Based on the source of the restriction imposed on the capital, there are two types of capital rationing viz. hard capital rationing and soft capital rationing.

Soft Capital Rationing:
It is when the restriction is imposed by the management.
Hard Capital Rationing:
It is when the capital infusion is limited by external sources.
Advantages and Disadvantages of Capital Rationing

Capital Rationing Decisions

Capital rationing decisions by managers are made to attain the optimum utilization of the available capital. It is not wrong to say that all the investments with positive NPV should be accepted but at the same time, the ground reality prevails that the availability of capital is limited. The option of achieving the best is ruled out and therefore, the rational approach is to make the most out of the on-hand capital.

Capital Rationing Method

The method of capital rationing can be bifurcated into four steps. The steps are

  1. Evaluation of all the investment proposals using the capital budgeting techniques of Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index (PI)
  2. Rank them based on various criterion viz. NPV, IRR, and Profitability Index
  3. Select the projects in descending order of their profitability till the capital budget exhausts based on each capital budgeting technique.
  4. Compare the result of each technique with respect to total NPV and select the best out of that.

Capital Budgeting Calculation with Example

Assume that we have the following list of projects with the below-mentioned cash outflow and their evaluation results based on IRR, NPV, and PI along with their respective rankings. The capital ceiling for investment is, say, 650.

ProjectsInitial Cash OutflowIRRNPVPIIRRNPVPI
A350   0.19   150.00   1.43625
B300   0.28   420.00   2.40211
C250   0.26     10.00   1.04366
D150   0.20   100.00   1.67554
E100   0.37   110.00   2.10143
F100   0.25   130.00   2.30432

In the table, if we select based on individual method, we will arrive at the following result:

E1001100.37 B300420 B3004202.4
B3004200.28 A350150 F1001302.3
C250100.26     E1001102.1
Total650540  Total650570 Total650760 

The results are quite obvious and we will go with B, F, E, and D to achieve a maximum value of 760.

Please note that for the sake of basic understanding, we have taken a simple example inspired by the book “Fundamentals of Financial Management” by Van Horne and Wachowicz.

Quiz on Capital Rationing

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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