What is Capital Rationing?
Capital rationing is a process of selecting the mix of acceptable projects that provides the highest overall Net Present Value (NPV) when a company has a limit on the budget for capital spending. The profitability index is used widely in ranking projects competing for limited funds.
Under such situation, managers use a number of capital budgeting methods such as accounting rate of return (ARR) method, net present value (NPV) method and internal rate of return (IRR) method to allocate money to various feasible projects.
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The main advantage of capital rationing is budgeting a company’s corporate resources. When a company issues stock or borrows money, it can use these resources for new investments.
However, if the company does not expect a good return on investments, it is wasting these resources. By capital rationing, the company can make sure it takes on fewer projects with highest positive NPV.
Further, it can take on only projects for which the anticipated return on investment is high as compared to others. It helps the company to efficiently allocate the funds available for investment.
Types of Capital Rationing
Soft rationing is when the firm itself limits the amount of capital that is going to be used for investment decision 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.
- Secondly, 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.
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 start-up 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.
Process of Capital Rationing
An effective capital rationing usually consists of the following three steps
- Step 1 In the first step of capital rationing, the alternative projects are screened using payback period and accounting rate of return methods. The Management sets maximum desired payback period or minimum required accounting rate of return for all competing alternative projects.
The payback period or accounting rate of return of various alternatives is then computed and compared to the management’s desired payback period and accounting rate of return.
- Step 2 In this step, the projects that pass the test in step 1 are further analysed using net present value and internal rate of return methods to know whether money should be allocated in such projects or not.
- Step 3 The projects which left after the screening of step 2 are ranked using a predetermined criteria and compared with the available funds. Finally, the projects are selected for funding. The projects that remain unfunded may be reconsidered on the availability of funds.