Chapter 6: Capital Rationing

What is Capital Rationing?

Capital rationing is a situation where a constraint or budget ceiling is placed on the total size of
capital expenditures during a particular period. It enables the organizations to determine an
optimal capital budgeting and adequate capital expenditure, in the long run.
Capital rationing refers to the selection of the investment proposals in a situation of constraint
on availability of capital funds to maximize the wealth of the company by selecting those
projects which will maximize overall NPV of the concern.
Capital rationing is a strategy used by companies or investors to limit the number of projects
they take on at a time. If there is a pool of available investments that are all expected to be
profitable, capital rationing helps the investor or business owner choose the most profitable
ones to pursue.
Companies that employ a capital rationing strategy typically produce a relatively higher return
on investment (ROI). This is simply because the company invests its resources where it
identifies the highest profit potential.
Example of Capital Rationing
Capital rationing is about putting restrictions on investments and projects taken on by a
business. To illustrate this better, let’s consider the following example:-
VV Construction is looking at five possible projects to invest in, as shown below:

To determine which project offers the greatest potential profitability, we compute each project
using the following formula:
Profitability = NPV / Investment Capital

Based on the table above, we can conclude that projects 1 and 2 offer the greatest potential
profit. Therefore, VV Construction will likely invest in those two projects.
What are the factors leading to capital rationing?
Two different types of capital rationing situation can be identified, distinguished by the source
of the capital expenditure constraint.
1. Internal Factors
Capital rationing is also caused by internal factors which are as follows:
  Reluctance to take resort to financing by external equities in order to avoid assumption
of further risk.
 Reluctance to broaden the equity share base for fear of losing control.
 Reluctance to accept some viable projects because of its inability to manage the firm in
the scale of operation resulting from inclusion of all the viable projects.
2. External Factors
Capital rationing may arise due to external factors like imperfections of capital market or
deficiencies in market information which might have for the availability of capital.
Generally, either the capital market itself or the Government will not supply unlimited amounts
of investment capital to a company, even though the company has identified investment
opportunities which would be able to produce the required return. Because of these
imperfections the firm may not get necessary amount of capital funds to carry out all the
profitable projects.

Types of Capital Rationing

There are two types of capital rationing –
1. Hard Capital Rationing
2. Soft Capital Rationing.
1. Hard capital rationing
Hard capital rationing represents rationing that is being imposed on a company by
circumstances beyond its control. For example, a company may be restricted from borrowing
money to finance new projects because it has suffered a downgrade in its credit rating. Thus, it
may be difficult or effectively impossible for the company to secure financing, or it may only be
able to do so at exorbitant interest rates.
2. Soft capital rationing
In contrast, soft capital rationing refers to a situation where a company has freely chosen to
impose some restrictions on its capital expenditures, even though it may have the ability to
make much higher capital investments than it chooses to. The company may choose from any of
a number of methods for imposing investment restrictions on itself. For example, it may
temporarily require that a project offer a higher rate of return than is usually required in order
for the company to consider pursuing it. Or the company may simply impose a limit on the
number of new projects that it will take on during the next 12 months.
Why is Capital Rationing Used? / Benefits/advantages of the Capital Rationing
Capital rationing is used by many investors and companies in the following reasons-
 To ensure that only the most feasible investments are made.
 It helps ensure that businesses will invest only in those projects that offer the highest
returns.
 It may appear that all investments with high projected returns should be taken.
 There are times when funds are low or when a company or an individual investor
merely want to improve their cash flows before making any more investments.
 It may also be the case that the investor has reason to believe that they can make the
investment under more favorable terms by waiting a bit longer before pursuing it.
1. Limited Numbers of Projects are Easier to Manage
When a company invests in a large number of projects simultaneously, the sharing of funds
means less capital available for each individual project. This typically translates to more time
and effort being required to monitor and manage each project. Also, allocating limited resources
across several projects may actually threaten the success of the projects, if, for example, the
projected budget for one or more projects turns out to have significantly underestimated costs.
Wise capital rationing can help a company avoid such problems.
2. Capital Rationing Offers Increased Investment Flexibility
Investment opportunities are constantly changing. Portfolio managers usually keep a significant
portion of available investment funds in the form of cash. Maintaining a ready supply of excess
cash, first of all, provides greater financial stability and makes it easier for investors to adjust to
sudden adverse circumstances that may arise.
Keeping some excess cash in reserve accomplishes something else as well. It ensures that if a
particularly attractive unseen golden opportunity should suddenly arise, the investor has funds
available to take immediate advantage of the situation. The ability to act quickly may be the
difference between a good investment opportunity and a great one.

Disadvantages of Capital Rationing

Capital rationing also comes with its own disadvantages, including the following:-
1. High capital requirements
Because only the most profitable investments are taken on under a capital rationing scenario,
rationing can also spell high capital requirements.
2. Goes against the efficient capital markets theory
Instead of investing in all projects that offer high profits, capital rationing only allows for
selecting the projects with the highest estimated returns on investment. But the efficient markets
theory holds that it is virtually impossible, over time, to continually select superior investments
that significantly outperform others. Capital rationing may, in fact, expose an investor to greater
risk by failing to hold a diversified investment portfolio.

Capital Rationing and Profitability Index

In the previous few articles we have come across different metrics that can be used to choose
amongst competing projects. These metrics help the company identify the project that will add
maximum value and helps make informed decisions to maximize the wealth of the firm. We
saw how the NPV rule was better than IRR and the profitability index and how decisions based
on NPV are supposedly more accurate.
However, we need to understand that there is a difference between how the NPV rule is stated
in text books and how it is applied in real life worldwide. This difference arises because when
we consider capital budgeting, we are working under the fundamental assumption that the firm
has access to efficient markets. This means that if the required rate of return is greater than the
opportunity cost of capital, or if the project has an NPV greater than zero, the firm can always
finance its projects by raising money from the markets even if it doesn’t have any. Thus for
practical purposes, the money at the firms disposal is unlimited.
However, in reality this may not be the case. True, that firms can always raise money and
bigger firms can raise as much funds as they want to, but many times firms themselves place
restrictions on the amount of fund raising that they undertake.
These restrictions could be placed because of the following reasons:
 Raising more equity could dilute the existing ownership interest
 There may be debt covenants preventing the firm from raising more debt
 Raising more funds either by debt or equity may make the firm appear riskier and may
take the cost of capital even higher
This restriction placed on the amount of capital that the company has, nullifies the assumption
inherent in capital budgeting. Thus, what happens in real life is a slightly modified version of
capital budgeting. Financial analysts have a name for this. They call it “Capital Rationing”.
So capital rationing is nothing but capital budgeting with modified rules. Now instead of
choosing every project that has an NPV greater than zero, the firm uses a different approach.
All projects with a positive NPV qualify for a possible investment. These projects are then
ranked according to their attractiveness. The firm then invests in the top3 or top 5 projects
(based on their resources). So, here a finite amount of capital is being rationed amongst projects
as opposed to an infinite capital assumption.
Profitability Index
But, how does the firm decide which projects are the most attractive? Simply ranking the
projects with higher NPV will be incorrect. This is because we are not paying attention to the
input we are putting in. We are simply paying attention to the output which is obviously
incorrect. What if a project with a slightly higher NPV requires double the investment as
compared to another project? Is it still a good bet?
Obviously not and to solve this problem and ration capital effectively, companies have come up
with a metric called the Profitability Index. The profitability index is nothing but the NPV of the
project divided by the amount of its investment.
Profitability Index = NPV / Investment
So we are simply looking at the NPV amount per dollar of investment. Projects with highest
NPV per dollar of investment are considered more attractive and the investment dollars are first
allocated to them so that the returns of the firm are maximized.

Types of Capital Rationing

As discussed in the previous article, capital rationing is a form of capital budgeting. In capital
rationing we change the unlimited capital assumption of capital budgeting and we try to choose
projects with the finite capital that we have on hand. This finite capital may be in the form of
capital that the firm already has or it may be in the form of a decision to raise a limited amount
of capital in the future. Either way, the amount of capital available at the company’s disposal for
decision making is finite and it is known. There are two types of capital rationing. They have
been explained in this article:
Soft Rationing
Soft rationing is when the firm itself limits the amount of capital that is going to be used for
investment decisions in a given time period. This could happen because of a variety of
reasons:
 The promoters may be of the opinion that if they raise too much capital too soon, they
may lose control of the firm’s operations. Rather, they may want to raise capital slowly
over a longer period of time and retain control. Besides if the firm is constantly
demonstrating a high level of proficiency in generating returns it may get a better
valuation when it raises capital in the future.
 Also, the management may be worried that if too much debt is raised it may
exponentially increase the risk raising the opportunity cost of capital. Most firms have
written guidelines regarding the amount of debt and capital that they plan to raise to
keep their liquidity and solvency ratios intact and these guidelines are usually adhered
to.
 Thirdly, many managers believe that they are taking decisions under imperfect market
conditions i.e. they do not know about the opportunities available in the future. Maybe a
project with a better rate of return can be found in the future or maybe the cost of capital
may decline in the future. Either way, the firm must conserve some capital for the
opportunities that may arise in the future. After all raising capital takes time and this
may lead to a missed opportunity!
This type of rationing is called soft because it is the firm’s internal decision. They can change or
modify it in the future if they think that it is in their best interest to do so.
Also, companies usually implement this kind of rationing on a department basis. From a master
investment budget, departmental investment budgets are drawn and each department is asked
to choose projects on the basis of funds allocated. Only in case of an extremely attractive project
are the departmental restrictions on capital investments compromised.
Hard Rationing
Hard rationing, on the other hand, is the limitation on capital that is forced by factors
external to the firm. This could also be due to a variety of reasons:
 For instance, a young startup firm may not be able to raise capital no matter how
lucrative their project looks on paper and how high the projected returns may be.
 Even medium sized companies are dependent on banks and institutional investors for
their capital as many of them are not listed on the stock exchange or do not have enough
credibility to sell debt to the common people.
 Lastly, large sized companies may face restrictions by existing investors such as banks
who place an upper limit on the amount of debt that can be issued before they make a
loan. Such covenants are laid down to ensure that the company does not borrow
excessively increasing risk and jeopardizing the investments of old lenders.
So hard rationing arises because of market imperfections and because of limitations created by
external parties.

Capital rationing
Capital rationing is essentially a management approach to allocating available funds across
multiple investment opportunities, increasing a company's bottom line. The company accepts
the combination of projects with the highest total net present value (NPV). The number one
goal of capital rationing is to ensure that a company does not over-invest in assets. Without
adequate rationing, a company might start realizing decreasingly low returns on investments
and may even face financial insolvency.
Two Types of Capital Rationing
In general, there are two primary methods for capital rationing:
1. The first type of capital, rationing, is referred to as "hard capital rationing." This occurs
when a company has issues raising additional funds, either through equity or debt. The
rationing arises from an external need to reduce spending and can lead to a shortage of
capital to finance future projects.
2. The second type of rationing is called "soft capital rationing," or internal rationing. This
type of rationing comes about due to the internal policies of a company. A fiscally
conservative company, for example, may have a high required return on capital to
accept a project, self-imposing its own capital rationing.
Examples of Capital Rationing
For example, suppose ABC Corp. has a cost of capital of 10% but that the company has
undertaken too many projects, many of which are incomplete. This causes the company's
actual return on investment to drop well below the 10% level. As a result, management decides
to place a cap on the number of new projects by raising the cost of capital for these new
projects to 15%. Starting fewer new projects would give the company more time and resources
to complete existing projects.
Capital rationing affects a company's bottom line and dictates the amount it can pay out in
dividends and reward shareholders. Using a real-world example, Cummins, Inc., a publicly-
traded company that provides natural gas engines and related technologies, needs to be very
cognizant of its capital rationing and how it affects its share price. As of March 2016, the
company's board of directors has decided to allocate its capital in such a way that it provides
investors with a dividend yield near 4%.
The company has rationed its capital so that its existing investments allow it to pay out
increasing dividends to its shareholders over the long-term. However, shareholders have come
to expect increasing dividend payouts, and any reduction in dividends can hurt its share price.
Therefore, the company needs to ration its capital and invest in projects efficiently, so it
increases its bottom line, allowing it to either increase its dividend yield or increase its actual
dividend per share.