Capital Rationing

What Is Capital Rationing?

Capital rationing refers to the situation where a company has more acceptable projects (i.e., projects with positive net present value or NPV) than it has capital available to invest. This forces the company to select among these projects, choosing only those that are most profitable or strategically aligned.

Firms engage in capital rationing when they invest in only a select group of projects rather than every single one available. Rationing is the controlled distribution of scarce resources, goods and services. It controls the size of the ration.

The technique to artificially control the supply and demand of commodities in economics is referred to as rationing. It's executed to ensure adequate distribution of resources without their inadequate utilization or wastage.

This rationing refers to a situation where a firm is not in a position to invest in all the projects present. This inability to invest in all the projects, even though they may be profitable, is due to the limited funds available.

The funds here are referred to as capital, a limited resource. It can be raised from debt or equity resources.

Debt is limited due to the credit that can be taken on, and equity is limited due to the constraints on the issuance of shares. The demand for these funds far exceeds the limited availability.

For this reason, a firm can't take on all the projects available, even after they are profitable. Instead, the company should select the most profitable project, or a combination of projects, that yields the greatest profit.

Understanding Capital Rationing

Capital rationing comes under capital budgeting. Capital budgeting pertains to the business process that involves evaluating major investment opportunities.

The firm must evaluate investment projects to weed out bad capital investments that may reduce the firm's value. Capital budgeting involves the acquisition of long-term assets that seek to maximize shareholders' wealth, and capital rationing refers to the strategy of picking the most profitable projects.

It is the activity of limiting the number of new investments/projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or setting an upper limit on specific budget portions.

It's selecting and investing in the most profitable project(s). Rationing is imposed when there isn't enough funding. It's the decision process that involves selecting projects when there are only limited funds available.

Management may restrict investments in certain parts of the business to emphasize investments in other areas.

Capital Rationing Assumptions

The first of the two assumptions about capital rationing is that there are restrictions on capital expenditure (CAPEX) such as internal financing restrictions or investment budget restrictions.  Secondly, we have to assume that the rationing can come out with an optimal return.

Why is capital Rationing Used? 

A few of the reasons of why capital rationing is used are:

1. Focus on Highest Returns

Wealth maximization and the selection of projects that will add to the firm's profitability are the essences of capital rationing. Therefore, management should allocate funding to the areas most likely to generate the highest returns.

Applying a higher cost of capital to net present value calculations tends to strip away lower-return projects. This approach improves short-term profits. This approach, however, may not enhance profits over the long term since it ignores strategic opportunities that may need long-term investments.

2. Focus on Strategy

Strategy is the plan of action. A plan of what is to be done. When, where, why, and by whom it's to be done. Strategy is based upon the mission and vision statement. It is based on a firm's strengths, weaknesses, opportunities, and threats.

Management should fund strategically important projects. This approach provides a long-term perspective and puts the organization in a long-term competitive position.

By doing this, however, the organization may end up choosing to put itself in the position to let go of the short-term profits.

3. Focus on Throughput

Bottlenecks are limitations or constraints in a business/manufacturing operation that slows down the cycle time. Here, cycle time is the time taken for the process to begin and end.

Management may decide to concentrate funds on bottleneck processes to increase throughput (the number of materials or products moving through a system or process).

By doing this, the bottleneck operation's capacity is increased, making it simpler to keep commitments.

4. Focus on the need

The need may arise for rationing when the organization doesn't have the funds to invest in all the projects, even after the projects are profitable.

The organization needs to invest in the projects to enhance its profitability. Other important goals are maximizing shareholders' wealth and ensuring returns spread throughout the years.

Approaches to Capital Rationing

The payback and the discounted payback methods are usually used in capital budgeting. But, since these two methods need to address the time value of money, NPV and PI are used.

Another method is the Accounting Rate of Return (ARR), which focuses on the accounting profits and returns rather than the economic or time-value adjusted cash flows. This is the reason we don't use ARR during rationing.

Net Present Value (NPV)

NPV is primarily used as a financial analysis technique to assess the feasibility of an investment or business. The technique shows the present value of the future cash flows compared to the initial investment.

With a business growing in size, the organization may make radical decisions to support its growth by investing in the right projects to enhance its profitability.

These capital investment decisions should be taken with immense care and in-depth project analysis. For this analysis, the organization may utilize the capital budgeting technique.

This technique is quite popular yet complicated. Net present value is nothing but the value of future cash inflows and outflows discounted to the present.

NPV = R_t /(1 + i)^t

^Where,

• t = Time of the cash flow
• i = Discount rate
• R_t= Net Cash Flow

The cash flows are to be discounted using a specific rate to derive the net present value. The rate is derived by the return-on-investment threshold of the organization or the rate of borrowing of the organization.

NPV considers the time value of money. Then, based on multiple variables, the cash flows are discounted. The time value of money means money earned today is worth more than the money earned tomorrow due to things like:

• Risk
• Inflations
• Opportunity costs

Once the cash flows are discounted and compared with the initial investment, if the NPV is positive, the organization may go ahead with the project. However, if the NPV is negative, the proposal is usually dropped.

Profitability Index (PI)

The profitability index is the ratio between cash flow inflows' present value and outflows' present value.

PI measures the monetary impact of each dollar earned for each dollar invested. The cash flows are converted into present value using the discount rates of either a selected required return on investment or the borrowing rate.

It compares the present value of the future cash flows (inflow) to the initial investment (outflow).

PI = present value of the future cash inflows/initial investment. The higher the PI, the more attractive the project is.

• If the PI => 1, accept the project.
• If the PI =< 1, reject the project.
• If the PI = 1, one is indifferent.

When PI is used together with the NPV, the interpretation is as follows:

• If the PI > 1, then the NPV is positive.
• If the PI < 1, the NPV is negative.

PI and NPV are closely related metrics. The PI measures the cash flows in relative terms. Alternatively, the NPV measures the project's profitability based upon the actual term in currency.

Types of Capital Rationing

The type of rationing to be used depends on the organization's situation. Either way, a Discounted cash flow analysis can provide a different perspective when deciding which project to go for. 

When faced with capital rationing, firms typically use various techniques to select among the available projects. Common methods include the profitability index, the internal rate of return (IRR), and the payback period. The objective is to maximize shareholder value within the constraints of available capital.

There are two types: hard and soft capital rationing. 

Hard Capital Rationing

This occurs when a company has difficulty raising funds. These funds can be acquired either through equity or debt. This rationing is forced on an organization by situations beyond its control.

The rationing arises from an external need to reduce spending and can lead to a shortage of capital to finance future projects.

Hard capital rationing is an external form of capital acquisition. The company isn't in a position to easily generate external funds to finance its investments. The reasons for hard capital rationing can be:

• Relatively, new companies and start-ups with inexperienced management cannot raise funds from the equity markets. This situation can arise even if the company is profitable and the investments are lucrative.
• Poor management and track records contribute unfavorably to the organization's fundraising ability. This is because lenders may refrain from extending loans and advances.
• Industry-specific factors may also contribute toward hard rationing. For example, some industries may have a high level of risk to be borne by lenders. Since the risks are high, the total cash flows and assets will be at risk too, which may cause problems while raising funds.
• The lenders may also restrict the firm from raising capital through external sources. In addition, the debt covenants of the firm can also prohibit them from borrowing funds under specific circumstances.

Soft Capital Rationing

Also known as internal rationing, it's executed due to internal policies and rules set by the board and the management. One example of a policy would be to accept only high-yield projects. Example: Only projects yielding an annual return higher than 12% will be considered.

A risk-averse and conservative organization would likely go for internal financing as management would assume they can pay internal stakeholders more easily than externally borrowed funds.

Soft capital rationing refers to limitations on the utilization of capital resources for different projects based on restrictions imposed by management and their decisions.

These restrictions are voluntary limitations created by management on the availability of funds for project investments. The reasons for soft capital rationing can be:

1. Decisions of the promoters: The company's promoters and stakeholders may decide to limit raising additional capital. This may be because of the fear of losing control of the company's operations. A better valuation may be achieved when raising capital in the future. That is why some may gradually prefer to raise funds over a long period to ensure control over the company.
2. The opportunity cost of capital: Too much leverage and the risk present in the capital structure may make a company a riskier investment. This leads to an increase in the opportunity cost of capital. Because of this, the firm may try to keep the liquidity and solvency ratios in check by limiting the funds raised by debt.
3. Future scenarios: Soft rationing is usually enacted by companies in the case of uncertainties allowing them to raise funds externally more easily.

Capital Rationing Advantages & Disadvantages

The advantages of Capital Rationing are:

• The rationing can help to ensure a budget is followed. Accepted projects can help management prepare financial statements and ensure budgets are prepared accordingly.
• By putting restrictions on investment policies, the firm promotes optimal utilization of resources with less wastage.
• As the number of active projects decreases, the management of those few may become more effective and efficient. Naturally, the workload reduces, hence leading to better analysis and results.
• Eliminates projects that have lower returns or are unprofitable.

Similarly, there are certain disadvantages of Capital Rationing, such as:

• This method will aid only in maximizing short-term profits rather than long-term growth. It can also lead to the rejection of extremely profitable projects simply because it may take a long time to see the returns.
• Using the rate of returns should be done with utmost care. Using the wrong capital cost can dilute a company's profits.
• Maximizing NPV is impossible since rationing favors short-term profitable growth. Moreover, the intermediate cash flows aren't maximized since the cash flows might be generated in later years.

Researched and authored by Farooq Azam Khan, CMA | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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