Capital Rationing – Its Assumptions, Advantages and Disadvantages

Capital rationing is a common practice in most companies as they have more profitable projects available for investment than the capital available. In theory, there is no place for capital rationing as companies should invest in all profitable projects. However, most companies follow capital rationing as a way to isolate and pick up the best projects under the existing capital restrictions. Let us see in detail the advantages and disadvantages of capital rationing.

Definition of Capital Rationing

Capital rationing is the process of putting restrictions on the projects undertaken by the company or the capital that the company can invest. This aims to choose only the most profitable investments for the capital investment decision. This can be accomplished by putting restrictive limits on the budget or selecting a higher cost of capital as the hurdle rate for all the projects under consideration. Capital rationing can be either hard or soft.

Read more about it at Capital Rationing.

Assumptions of Capital Rationing

The primary assumption of capital rationing is that there are restrictions on capital expenditures either through ‘all internal financing’ or’ ‘investment budget restriction’’. Firms do not have unlimited funds available to invest in all the projects. It also assumes that capital rationing can achieve an optimal return on investment for the company, whether by a normal trial and error process or by implementing mathematical techniques like integer, linear, or goal programming.

Capital RationingAdvantages of Capital Rationing

Capital rationing is a very prevalent situation in companies. There are a few advantages of practicing capital rationing:

Budget

The first and important advantage is that capital rationing introduces a sense of strict budgeting of the corporate resources of a company. Whenever there is an injunction of capital in the form of more borrowings or stock issuance capital, the resources are properly handled and invested in profitable projects. 

No Wastage

Capital rationing prevents wastage of resources by not investing in each new project available for investment.

Fewer Projects

Capital rationing ensures that less number of projects are selected by imposing capital restrictions. This helps keep the number of active projects to a minimum and thus manage them well.

Higher Returns

Through capital rationing, companies invest only in projects where the expected return is high, thus eliminating projects with lower returns on capital.

More Stability

As the company is not investing in every project, the finances are not over-extended. This helps in having adequate finances for tough times and ensures more stability and an increase in the company’s stock price.
Capital Rationing

Disadvantages of Capital Rationing

Capital rationing comes with its own set of disadvantages as well. Let us describe the problems that rationing can lead to:

Efficient Capital Markets

Under efficient capital markets theory, all the projects that add to the company’s value and increase shareholders’ wealth should be invested. However, this theory is violated by following capital rationing and investing in only certain projects.

The Cost of Capital

In addition to limits on budget, capital rationing also places selective criteria on the cost of capital of shortlisted projects. However, to follow this restriction, a firm has to be very accurate in calculating the cost of capital. Any miscalculation could result in selecting a less profitable project.

Un-Maximizing Value

Capital rationing does not allow for maximizing the maximum value creation as all profitable projects are not accepted, and thus, the NPV is not maximized.

Small Projects

Capital rationing may lead to selecting small projects rather than larger-scale investments.

Intermediate Cash Flows

Capital rationing does not add intermediate cash flows from a project while evaluating the projects. It bases its decision only on the final returns from the project. Intermediate cash flows should be considered in keeping the time value of money in mind.

Conclusion

Though capital rationing has few disadvantages, it is still followed widely in selecting investment projects. A company should decide on following capital rationing after studying the implications in detail.



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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