What is Capital Rationing?
Capital rationing is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a budget.
Companies may want to implement capital rationing in situations where past returns of an investment were lower than expected.
In financial modelling, capital rationing can impact the valuation of a company or project. When there is a limit on the amount of funds available, the company or project may be worth less than if it had an unlimited supply of capital. This is because there is a higher risk that the company or project will not be able to get the money it needs to continue operations. As a result, investors may be less willing to invest in the company or project, which will lower its value.
What Does Capital Rationing Mean?
The main objective of capital rationing is the maximization of shareholder wealth. In this context, a firm may decide to implement capital rationing by seeking new investment opportunities with a higher net present value as well as setting a higher ceiling on the cost of capital. In doing so, the firm can assume control over its resources and undertake fewer projects or projects with a higher expected return on investment.
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.
So, Capital Rationing is the decision process used to select capital projects when there is a limited amount of funding available. Rationing may also be imposed when there is enough funding, but management is restricting it from certain parts of the business in order to emphasize investments in other areas. There are a number of ways to engage in capital rationing, including the following:
Focus on Highest Returns
Management could allocate funding just to those areas most likely to generate the highest returns. A variation is to apply a higher cost of capital to net present value calculations to strip away lower-return projects. This approach improves short-term profits, but may not enhance profits over the long-term, since it ignores strategic changes that may require long-term investments.
Focus on Strategy
Management could channel funding toward strategically important areas. Doing so provides good long-term competitive positioning for the business, but possibly at the cost of a short-term decline in profits.
Focus on Throughput
Management could focus funding on bottleneck operations to enhance throughput. Doing so increases the capacity of the bottleneck operation, making it easier to meet order commitments made to customers.
Types of Capital Rationing
There are two types of capital rationing:
- Soft rationing;
- Hard 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, 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.
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.