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.
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.
Types of Capital Rationing
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.
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.
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.
Evaluation
Ranking
Projects
Initial Cash Outflow
IRR
NPV
PI
IRR
NPV
PI
A
350
19%
150
1.43
6
2
5
B
300
28%
420
2.4
2
1
1
C
250
26%
10
1.04
3
6
6
D
150
20%
100
1.67
5
5
4
E
100
37%
110
2.1
1
4
3
F
100
25%
130
2.3
4
3
2
In the table, if we select based on individual method, we will arrive at the following result:
IRR
NPV
PI
Projects
ICO
NPV
IRR
Projects
ICO
NPV
Projects
ICO
NPV
PI
E
100
110
37%
B
300
420
B
300
420
2.4
B
300
420
28%
A
350
150
F
100
130
2.3
C
250
10
26%
E
100
110
2.1
D
150
100
1.67
Total
650
540
Total
650
570
Total
650
760
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
Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.
Simple and easy to understand
Very Very Simple & clear to understand.