What is Capital Rationing?
Capital rationing is a technique of selecting the projects that maximize the firm’s value when the capital infusion is restricted. The calculation and method prescribe arranging projects in descending order of their profitability. Capital budgeting techniques such as IRR, NPV, and PI are very useful in selecting the optimal combination.
A firm may often 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 firm’s investment policy, 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 maximize wealth. This process of evaluation and selection of a project is called capital rationing. Therefore, the capital rationing process aims to distribute limited resources in such a way that generates the maximum possible cash flows.
Definition of Capital Rationing
Capital rationing is a process of distributing available capital among the various investment proposals by the way of capital budgeting so that the firm achieves a maximum increase in its value.
Based on the source of the restriction imposed on the capital, there are two types of capital rationing: hard and soft capital rationing.
Soft Capital Rationing
It is when the management imposes the restriction.
Hard Capital Rationing
It is when external sources limit the capital infusion.
Capital Rationing Decisions
These decisions are made by managers to attain the optimum utilization of the available capital. It is not wrong to say that all investments with positive NPV should be accepted. Still, 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 this concept can be bifurcated into four steps. The steps are:
- Evaluate all the investment proposals using capital budgeting techniques. Such as Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI)
- Rank them based on various criteria, viz. NPV, IRR, and Profitability Index
- Select the projects in descending order of profitability until the capital budget exhausts using 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 the below-mentioned cash outflow and their evaluation results based on IRR, NPV, PI, and their respective rankings. The capital ceiling for investment is, say, 650.
|Projects||Initial Cash Outflow||IRR||NPV||PI||IRR||NPV||PI|
In the table, if we select based on individual method, we will arrive at the following result:
The results are pretty obvious, and we will go with B, F, E, and D to achieve a maximum value of 760.
Please note that for 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
Answering the following simple questions will let you help in analyzing what you have learned from the above article