What is Capital Rationing?
Capital rationing refers to thought-through strategy companies apply to limit the number of projects they take up at a particular time, such that the business owners/management decide to go ahead with good and profitable projects, which helps them achieve higher profits within the limited capital range.
Objectives of Capital Rationing
The main objective of capital rationing is to achieve maximum profitability with limited resources available.
Also, remember that the initial investment, as estimated, may be outrun because of some misjudgment or missing out on certain exposures. Additional investment may be required once the project has been initiated. Thus, it’s a great idea not to block all resources in varied projects, which will eventually hamper the profits from each of them.
On the other hand, with limited projects, the company may be able to focus better on handling each project efficiently.
Examples of Capital Rationing
An example would be a nice idea to understand the concept better.
A simple example can be a company engaged in construction projects. MNP & Co. are looking to invest in 4 options available. The estimated cost of the project and the net present value of each project is given below.
Now, based on these details, one can find the project’s profitability by simply dividing the project’s net present value by the investment made.
| Project | Capital Investment required | Net Present Value | Profitability ratio= (Net Present Value / Capital investment | |
| 1 | $ 50 million | $ 60 million | $ 60 million / $ 50 million = | 1.2 |
| 2 | $ 20 million | $ 22 million | $ 22 million / $ 20 million = | 1.1 |
| 3 | $ 40 million | $ 30 million | $ 30 million / $ 40 million = | 0.75 |
| 4 | $ 60 million | $ 60 million | $ 60 million / $ 60 million = | 1 |
Assuming no limitation on the capital available, a company may prioritize taking up Projects 1 and 2, respectively, as they offer higher profitability potential, and then Project 4 and, lastly, Project 3, in the order.
In case the company has limited resources available, say, $ 60 million, in such a case, it may go ahead with only 1 project offering the highest profitability based on the case given above.
Types of Capital Rationing
Capital rationing can be bifurcated into two types:
- Hard capital rationing: mostly represented by restrictions imposed on a company beyond its power and control. Examples include small to medium-sized companies with borrowing available at extremely high-interest rates or limited borrowing capacity of the company on account of its credit rating or past records.
- Soft capital rationing: mostly represented by restrictions imposed by the company on its own, which are well within its power and control. Examples include putting a cap on expenditure to be incurred, selecting the project to take, promoters deciding to take on only a particular loan amount to maintain their control, etc., which are part of soft capital rationing.
Reasons for Capital Rationing
There can be various reasons. Some of them are listed below:
- Higher revenue/returns with a limited amount of capital by eliminating projects with a lower rate of return.
- Better finance management offers stability to the company by getting an idea about the total investment amount required for the project/projects.
- Better financial control over the investments and expenses of the company eventually helps the company in having enough finance readily available in case of any need, thus helping the company market and goodwill intact.
- Utilization of funds available with the company to the fullest capacity.
- This will entail discarding the lower profitable projects, thus the company having to manage only a few projects, the resources for which can be managed efficiently and effectively whether in terms of investment made or human talent and resources.
Assumptions of Capital Rationing
The whole concept of capital rationing is based on the primary assumption that the company has limited resources for capital investment. Furthermore, it assumes that there are restrictions in place, either internal or external, either hard capital rationing or soft capital rationing.
It would not be wrong to say that any company/organization would not have unlimited funds available to undertake capital expenditure or invest in all available projects. Thus capital rationing is considered the same the foremost assumption takes the same as starting point of all strategic decisions to be made by the company from a capital rationing perspective.
Benefits
- High profitability project selection means high revenue for the company.
- Less number of projects to handle means better efficiency in each project.
- The company is free to select the project based on investment and profit aspects.
- It is helpful in constantly changing economic scenarios.
- It helps in taking up the best projects from the profit feasibility aspect.
Disadvantages
- Huge capital availability requirements as high profitability projects may also entail higher investment needs.
- Selecting projects with only higher profitability each time may not be feasible every time an investment is to be made.
- The projects are selected only to estimate profitability. Therefore, actual profits may be higher than the estimates, but the project may have been discarded basis low profitability estimates.
- Risks in selecting only high-profit projects involve higher investment and a larger timeframe to conclude, thus blocking the capital for a longer period.
Key Takeaways
- Companies take up capital rationing to limit the amount to be kept separate and used for a said project, aiming to achieve higher profitability without running into cash crunch issues.
Conclusion
To summarize our whole discussion in simple words, a capital rationing strategy helps the company achieve higher profits and, ultimately, higher return on investment by investing in projects with the highest profit-earning potential within their limited resources.
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