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 times there are capital restrictions. This restriction may be 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, finance manager would accept a combination of those projects, totaling less than the capital ceiling, to achieve maximization of wealth. This process of evaluation and selection of a project is called capital rationing.
Definition of Capital Rationing
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It can be defined as a process of distributing available capital among the various investment proposals in such a manner that the firm achieves maximum increase in its value.
Types of Capital Rationing
Based on the source of 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, rational approach is to make most out of the on-hand capital.
Capital Rationing Method
The method of capital rationing can be bifurcated in four steps. The steps are
- 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)
- Rank them based on various criterion viz. NPV, IRR, and Profitability Index
- Select the projects in descending order of their profitability till the capital budget exhausts based on each capital budgeting technique.
- 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 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.
Evaluation | Ranking | ||||||
Projects | Initial Cash Outflow | IRR | NPV | PI | IRR | NPV | PI |
A | 350 | 0.19 | 150.00 | 1.43 | 6 | 2 | 5 |
B | 300 | 0.28 | 420.00 | 2.40 | 2 | 1 | 1 |
C | 250 | 0.26 | 10.00 | 1.04 | 3 | 6 | 6 |
D | 150 | 0.20 | 100.00 | 1.67 | 5 | 5 | 4 |
E | 100 | 0.37 | 110.00 | 2.10 | 1 | 4 | 3 |
F | 100 | 0.25 | 130.00 | 2.30 | 4 | 3 | 2 |
In the table, if we select based on individual method, we will arrive at following result:
IRR | NPV | PI | ||||||||||
Projects | ICO | NPV | IRR | Projects | ICO | NPV | Projects | ICO | NPV | PI | ||
E | 100 | 110 | 0.37 | B | 300 | 420 | B | 300 | 420 | 2.4 | ||
B | 300 | 420 | 0.28 | A | 350 | 150 | F | 100 | 130 | 2.3 | ||
C | 250 | 10 | 0.26 | E | 100 | 110 | 2.1 | |||||
D | 150 | 100 | 1.67 | |||||||||
Total | 650 | 540 | Total | 650 | 570 | Total | 650 | 760 |
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The results are quite obvious and we will go with B,F,E and D to achieve 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.
2 Responses
Simple and easy to understand
Very Very Simple & clear to understand.