What is Capital Rationing?
Capital Rationing Definition
Capital rationing happens when a business has insufficient funds to undertake all profitable projects currently available.
Therefore, the business must limit which projects they decide to undertake based on their available funds.
In other words, a business with limited funds would need to choose which projects to take on in order to optimise returns (or Net Present Value NPV).
Under the capital rationing method, projects are ranked in order of profitability to help the business decide the optimal way of using their investment funds.
In theory, if investment funds are unlimited, then a business should undertake all profitable projects.
Types of Capital Rationing
There are two types of capital rationing:
- Hard capital rationing
- Soft capital rationing
Hard Capital Rationing
Hard capital rationing occurs when external factors enforce limits on the amount of capital expenditure.
For example, a startup company might have difficulty securing loans from banks due to its lack of established credit history or collateral.
As a result, they might not have the capital available to invest in any potential profitable projects.
Soft Capital Rationing
Soft capital rationing occurs when internal factors enforce limits on the amount of capital expenditure.
Soft capital rationing typically involves internal constraints imposed by management, where the decision to limit capital expenditure is discretionary and based on strategic considerations.
For example, a technology company might choose not to pursue a high-risk, high-reward research project because it prefers to hold high levels of cash for liquidity purposes.
Profitability Index (PI)
The profitability index aims to maximise NPV by ranking the outcomes by NPV per invested amount.
The formula for the profitability index is:
Profitability Index = NPV / Investment
Capital Rationing Examples
Let’s now look at an example of the capital rationing method, ranking the results by NPV and also the profitability index.
Assume a company has a budget of £500,000 and four prospective projects available:
Project | Investment Required | NPV |
A | £100,000 | £50,000 |
B | £150,000 | £70,000 |
C | £300,000 | £120,000 |
D | £400,000 | £100,000 |
Ranking By NPV
Ranking by NPV is a straightforward process of ordering the NPV from highest to lowest:
Project | Investment Required | NPV | NPV Rank |
A | £100,000 | £50,000 | 4 |
B | £150,000 | £70,000 | 3 |
C | £300,000 | £120,000 | 1 |
D | £400,000 | £100,000 | 2 |
Ranking by Profitability Index
To rank the project by the profitability index, we need to use the profitability index formula and then rank from highest to lowest:
Project | Investment Required | NPV | PI | PI Rank |
A | £100,000 | £50,000 | 0.50 | 1 |
B | £150,000 | £70,000 | 0.47 | 2 |
C | £300,000 | £120,000 | 0.4 | 3 |
D | £400,000 | £100,000 | 0.25 | 4 |
Advantages of Capital Rationing
Capital rationing provides businesses with several benefits such as:
Return on Investment
By carefully selecting projects with the highest potential returns and allocating available capital, companies can maximise their return on investment.
Risk Management
Capital rationing helps companies manage risk by avoiding the allocation of funds to unprofitable or less profitable projects when better alternatives exist.
Resource Efficiency
By selectively investing in projects, the company avoids stretching its finances too thinly.
This prudent approach ensures sufficient cash reserves are maintained for challenging periods, rather than just using the capital to invest in every single project available.