What is Capital Rationing?
Capital rationing refers to a thought-through strategy applied by companies 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. It is possible that additional investment may be required once the project has been initiated. Thus, it’s a great idea to not block all resources in varied projects, which will eventually hamper the profits from each of them.
On the other hand, with limited projects in hand, 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 of 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 profitability of the project by simply dividing the net present value of the project 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 that have 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 such as putting a cap on expenditure to be incurred, selecting the project to take, promoters deciding to take on only a particular amount of loan so as to maintain their control, etc., 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 helping 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.
- Capital rationing 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 in terms of capital investment to be made. Furthermore, it stands on the assumption 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 an unlimited source of funds available with them to undertake capital expenditure or invest in all available projects, and thus capital rationing considered the same as foremost assumption takes the same as starting point of all strategic decisions to be made by the company from capital rationing perspective.
- 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 decide to select the project based on investment and profit aspects.
- It is helpful in constantly changing economic scenarios.
- Helps in taking up the best projects from the profit feasibility aspect.
- Huge capital availability requirements as high profitability projects may also entail higher investments 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 estimated profitability. Therefore, it is possible that actual profits may be higher than the estimates, but the project may have been discarded basis low profitability estimates.
- Risks involved in selecting only high-profit projects involve higher investment and a larger timeframe to conclude, thus blocking the capital for a longer period of time.
- Companies take up capital rationing to place limitations on the amount to be kept separate and used for a said project, with the main aim to achieve higher profitability without running into cash crunch issues.
To sum up our whole discussion in simple words, capital rationing strategy helps the company achieve higher profits and ultimately higher return on investment by investing in projects which have the highest profit earning potential within their limited resources.
This is a guide to Capital Rationing. Here we also discuss the definition, objectives, examples, and types of Capital Rationing along with benefits and disadvantages. You may also have a look at the following articles to learn more –