What is Capital Rationing?
Capital Rationing is a process or a method applied to select and allocate a combination of project mix in a manner which maof shareholder’s wealth with limited initial investment amount available for investing in several projects under consideration.
Example of Capital Rationing
Let us take an example to understand the concept better.
Suppose there is a company named Yuva Constructions Ltd (‘YCL’). YCL is engaged in the business of construction of buildings for residential and commercial purposes. Now, it has secured the required preliminary permissions and approvals from the state government for constructing 3 projects – Project A, B, and C.
YCL has a total budget of $10 billion. Project A, B, and C are expected to yield total value (present value of cash flows) of $7 billion, $8 billion, and $6 billion respectively viz a viz the initial investment required for each is $5 billion, $6 billion and $5 billion respectively. Apply the Capital rationing and find the optimal combination.
First, let’s tabulate the information provided to us for ease of reference.
- Now, YCL has $10 billion and in order to maximize the investors’ wealth, it will have to accept projects in such a manner that it receives the highest amount of profits within the limited budget of $10 million. Accordingly, it will have to find out the expected rate of return for all the projects and then rank them according to profitability index.
The below table explains the same in a simple manner.
- Now, based on the ranks, YCL must select Project A and B, as they have the highest profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.. However, the total initial investment which will be required if it chooses Project A and B would exceed the available funding i.e it will require $11 billion ($5 billion + $6 billion) as compared to available $10 billion.
- In such a situation, it will have to discard 1 project and move to the next ranking project which suits his investment needs. Thus, YCL will have the option to go ahead with Project A and C which will entail an investment well within the available capital of $10 billion and will have to forego investing in Project B.
It can be segregated based on two types. First is known as Hard rationing and others referred to as Soft rationing.
- Hard Capital Rationing means when the additional capital infusion or any restriction on the use of existing investment funding is limited by forces of external sources.
- Soft Capital Rationing refers to restrictions on the use of capital funding for various projects is on account of restrictions imposed by management and its decisions.
Some of the assumptions are as follows.
- The primary assumption made is that there is a restriction imposed, either through internal forces or external, on the use of capital funding.
- The other assumption followed here, is that there several projects to be undertaken by the company or investors and that selecting certain projects will help in optimized returns for the investment made.
- Lastly, the concept of capital rationing is based on assumption that the expected rate of return of proposed projects to be undertaken shall be achieved as expected, thus ignoring practical factors such as economics, politics, policies, and such.
- The increased cost of capital for higher capital/funding requirements.
- Higher debt in books of the company.
- Any internal management restriction.
- Lack of human resources or knowledge for undertaking all the projects.
Capital Rationing vs Unlimited Funds
|Capital Rationing||Unlimited Funds|
|A situation with fixed capitalFixed CapitalFixed capital refers to the investment made by the business for acquiring long term assets. These long term assets don’t directly produce anything but help the company with long-term benefits. in hand and to choose the projects based on profitability.||A situation with no cap on capital/funding available and thus undertake any project with suitable profitability.|
|You select the project based on ranking arrived by considering the rate of return and fixed capital investment.||You either accept or reject the project based on the required acceptance criterion.|
|The focus is on maximizing shareholder wealthMaximizing Shareholder WealthWealth maximization means the maximization of the shareholder’s wealth as a result of an increase in share price thereby increasing the market capitalization of the company. The share price increase is a direct function of how competitive the company is, its positioning, growth strategy, and how it generates profits..||The focus is on generating at least minimum acceptable returns.|
|There may be funds idle post applying capital rationing.||Investors utilized all the money and make investments.|
The use of capital rationing does come with its shares of advantages and benefits for the users. Some of the benefits are as follows.
- Any restriction on the use of available resources, in our case money, will result in utilizing the resource in the best optimal manner.
- The management or the investors of the company would not invest in any project coming their way without getting into detailed analysis. This ensures there is no wastage or unnecessary use of free funds available.
- By following the optimal utilization process, the investors would receive the highest or maximum returns on their investments.
- It may entail investing in only a few projects, which would help the management put in lesser efforts in managing the affairs of the projects and yield better results.
- The company or the investor will have funds available even after investing in the projects thus ensuring there is no cash crunch.
Some of the limitations are as follows.
- It focuses on investing in fewer projects, which ends up keeping the balance shareholder funds idle.
- The concept of capital rationing is based on the assumption that the project will yield a particular return. Any miscalculation of the same would end up the project in yielding lesser profits.
- It is possible that projects which are selected are of smaller duration, this would lead to discarding certain long-term projects, which may be healthy for the company’s stability.
- During the evaluation process, it ignores any intermediate cash flows which the project may have and also the time value associated with such cash flows.
Capital rationing is a process of selecting a project mix that will provide the maximum profit by investing the limited capital available in various projects. The process is followed after considering the restrictions in place, whether on account of internal or external forces, for the investments to be made.
This has been a guide to what is Capital Rationing and its meaning. Here we discuss an example and two types (Hard and soft rationing) of capital rationing with their assumptions, causes, and differences. You may refer to the following articles to learn more about finance –