Companies have to make different decisions regarding their operations during their lifetime. Some of these decisions may relate to the projects that they should undertake, while some may relate to strategies and operations. Decisions regarding the projects and investments of a company fall under capital budgeting. Capital budgeting is the process of evaluating different projects and making decisions regarding them. Usually, companies need capital budgeting to decide the most efficient and effective use of their resources. They achieve the process by using several techniques to do so. A proper capital budgeting process can help companies maximize their profits and minimize costs.
There are several tools that companies use during the capital budgeting process. These may include investment appraisal techniques such as payback period, net present value, internal rate of return, discounted payback period, etc. While each of these techniques shows different aspects of decision-making, the ultimate decision a company will make depends on the type of capital budgeting decision. There are different types of capital budgeting decisions that companies can make. For example, they can use capital budgeting for accept-reject decisions and mutually exclusive projects. Among these decisions, companies may also make capital rationing decisions.
What is Capital Rationing?
Capital rationing is a part of the capital budgeting process of a company in which it places restrictions on the capital it uses for new projects or investments. Companies can also use capital rationing to limit the number of projects that they undertake at a single time. Capital rationing decisions can be difficult to make sometimes. It is because companies may come across several projects that they expect to be profitable. In these conditions, it helps them find the project with the maximum returns.
The goal of the capital rationing process of a company is to ensure the most efficient and effective use of its resources. Usually, companies don’t have an infinite pool of resources. Therefore, they must always make decisions related to the best use of those resources and allocate it accordingly. It ascertains that companies not only maximize their returns but also don’t fall short of those resources. To do so, companies must accept a combination of projects and investments with the highest total net present value. One of the top goals of the capital rationing process is to discourage overinvestment in projects.
Two types of Capital Rationing
There are two methods for capital rationing. These are known as soft and hard capital rationing.
Hard Capital Rationing
Hard capital rationing refers to the capital rationing that is circumstantial and imposed on a company. In other words, it represents capital rationing that a company is forced into and does not have control over. Hard capital rationing usually occurs due to the inability of a company to generate funds. When it can’t get new finance, the company will need to reduce its spending. Similarly, a shortage of finance can force the company into problems in the future as well. For example, when a company has bad credit ratings, it may not be able to get new finance. Therefore, it will need to work with limited resources.
Soft Capital Rationing
Soft capital rationing is the opposite of hard capital rationing. Unlike hard capital rationing, a company is not forced into capital rationing in this case. Instead, the company choose to impose restrictions over its expenditures, even though it may have enough resources to invest in even further projects. Therefore, a soft capital rationing is inside the control of the company. When a company choose to implement a soft capital rationing, it may use many different techniques to achieve it. For example, it may raise its project acceptance requirements, so only worthwhile projects get accepted.
Divisible vs Non-Divisible Projects
When using capital rationing, companies will come across several projects that are feasible. However, they will need to select projects based on their requirements. Choosing these projects will depend on several factors. One of these factors is the divisibility of the projects. If a firm is experiencing no capital rationing, then it will not need to differentiate between divisible and non-divisible projects.
Divisible Projects
Divisible projects refer to the projects that a company can accept or reject partly. These projects are not related or do not depend on other components. With divisible projects, companies must first calculate the profitability index and the net present value of the project. Then they must rank different divisible projects based on the calculation and select the best option accordingly. It will ensure the returns on the project are maximized for the company.
Non-divisible projects
Non-divisible projects are those that can only be accepted or rejected wholly. They are the opposite of divisible projects. Therefore, a company cannot take non-divisible projects partly. With non-divisible projects, companies must make a list of all feasible combinations of projects within the set restraint of resources. Once they enlist the projects, they can choose the combination that maximizes the returns for their shareholders.
Common Appraisal Techniques in Capital Rationing
As mentioned above, the most common appraisal techniques in capital rationing are profitability index and net present value. Profitability index represents an index which describes the relationship between the total costs of a project and the expected benefits from it. To calculate the profitability index, a company must take the ratio between the present value of the expected cash flows and the initial amount of investment required for a project. In other words, it is NPV of the project divided over its required initial investment. The higher the profitability index of a project is, the better it is for the company.
Net present value is a method in which a company must deduct the present value of all expected future cash flows of a project from its initial investment required. This technique is one of the most commonly used techniques, not only capital rationing but other capital budgeting decisions as well. A project with a positive NPV is considered feasible for a company and will maximize its shareholders’ wealth. When comparing two projects, the project with a higher NPV is preferable.
Example
Capital rationing can last for different periods of time. Sometimes it can be a single period while other times it can be multiple periods. For single period capital rationing, the decision-making is straightforward, based on the techniques discussed above.
Simple Capital Rationing
For example, a company, ABC Co., has to choose between two projects. The results for the investment appraisal of both projects is as below.
| Technique | Project A | Project B |
|---|---|---|
| Net Present Value | $ 12,981 | $ 14,522 |
| profitability Index | 1.2 | 1.4 |
With the above decision, the decision is straightforward. Since both the NPV and PI of Project B are higher as compared to Project A, ABC Co. will select Project B. The company may also differentiate between divisible and non-divisible projects in single-period capital rationing.
With multiple period capital rationing, the decision rule isn’t as straightforward. By using PI or NPV, companies cannot determine the capital rationing for multiple-period scenarios. Instead, they must first determine the limiting factor in the capital rationing process. Then they must use linear programming techniques to make decisions.
Linear programming can be applied to a multi-period capital rationing in two ways. The company can either find a solution that maximizes the total NPV of the projects or a solution that maximizes the shareholders’ wealth through maximizing the present value of cash flow available for dividends. Usually, both these techniques will result in the same project selections.
Single Period Capital Rationing with Divisible Projects
Now, let’s go through another example.
Suppose that ABC Co has other four projects, W, X, Y and Z. Below is the extract data table:
| Project | Initial Investment | Present value of cash inflows | NPV |
|---|---|---|---|
| W | (10,000) | 11,095 | 1,095 |
| X | (20,000) | 20,849 | 849 |
| Y | (25,000) | 26,536 | 1,536 |
| Z | (30,000) | 32,222 | 2,222 |
Without capital rationing, the four projects are worthwhile to invest because they provide positive NPV. However, when there is capital rationing, we will not have enough resource to invest in all those four projects. Thus; ABC Co needs to select the best projects to invest in accordance with its available resource.
In order to determine the best alternative when there is limited resource, we need to rank those four projects based on NPV and PI.
Below table is the single period capital rationing as result of the ranking based on both NPV and PI.
| Project | Initial investment | Present value of cash inflows | NPV | Profitability Index (PI) | Ranking as per NPV | Ranking as per PI |
|---|---|---|---|---|---|---|
| W | (10,000) | 11,095 | 1,095 | 1.11 | 3 | 1 |
| X | (20,000) | 20,849 | 849 | 1.04 | 4 | 4 |
| Y | (25,000) | 26,536 | 1,536 | 1.06 | 2 | 3 |
| Z | (30,000) | 32,222 | 2,222 | 1.07 | 1 | 2 |
Suppose ABC Co has only $60,000 available capital investment. Thus; ABC Co cannot invest in those four projects.
NPV as Decision Criteria
Let’s see if we use NPV as an option for selection criteria. By using NPV, we will choose project Z first then project Y and the remaining for project W. We get the below table.
| Project | Priority | Outlay | NPV | Remark |
|---|---|---|---|---|
| Z | 1st | 30,000 | 2,222 | |
| Y | 2nd | 25,000 | 1,536 | |
| W (Balancing) | 3rd | 5,000 | 547 | (1/2 of $1,095) |
| Total | 60,000 | 4,304 |
By using the NPV as decision making, the combined projects Z, Y and W could generate combined NPV of $4,304.
Profitability Index as Decision Criteria
Now, let’s see if ABC Co uses PI as an investment decision. By using PI, ABC Co would choose project W, Z and Project 3. Then we get the summary table below:
| Project | Priority | Outlay | NPV | Remark |
|---|---|---|---|---|
| W | 1st | 10,000 | 1,095 | |
| Z | 2nd | 30,000 | 2,222 | |
| Y (Balancing) | 3rd | 20,000 | 1,228 | (20/25 of $1,536) |
| Total | 60,000 | 4,545 |
By choosing the projects based on PI, the resulting combined NPV is totally $4,545 for the maximum capital investment of $60,000.
Single Period Capital Rationing with Non-Divisible Projects
In single period capital rationing, if the projects are not divisible, the selection based on the above example is no longer applicable. In addition, it will not result in optimal solution. This is because the small portion of unused capital cannot be invested in other projects listed. In this case, the best way to find out the optimal combination is by using trial and error. This allows us to test the NPV available from different combination of projects. And any remaining portion of unused capital shall need to other thing else other than the projects listed above.
Now, let’s continue from the example above and assume that the four projects are non-divisible.
| Project | Required investment | PV of inflows | NPV from projects |
|---|---|---|---|
| W, X and Y | 55,000 | 58,479 | 3,479 |
| Y and Z | 55,000 | 58,757 | 3,757 |
| W and Z | 40,000 | 43,316 | 3,316 |
| X and Z | 50,000 | 53,071 | 3,071 |
From the above table, the highest NPV can be achieved by investing in combination of projects Y and Z. This combination generates total NPV of $3,757. The remaining unused capital of $5,000 can be used to invest externally where appropriate.
Practical Methods of Dealing with Capital Rationing
Practically, companies can deal with capital rationing in many different ways. Usually, before capital rationing, companies decide on an acceptable rate of return. It is the basis for capital rationing as it will dictate which projects will get considered and which won’t. Once the decision gets made, companies can start evaluating different projects.
With capital rationing projects, not only is their return important, but the duration is also crucial. Therefore, companies also consider the time it takes for projects to return the expected results. It is because the longer the resources of a company are tied in a project, the more opportunities it will miss with other projects. Therefore, time is also vital.
Once all aspects are considered, a company can make decisions regarding which projects are feasible. Just because all the projects are feasible, doesn’t mean it should accept all investment proposals. It should consider all its options before making a final decision.
Advantages
Capital rationing is a vital process for almost all companies, especially ones with limited resources. The process ensures a company maximizes its profits and only invest in projects that offer the highest returns. It can also help in the budgeting process of a business. That is, mainly, because it helps in the best allocation of resources. It also ensures limited or no wastage in the process of a company. It is also important because it focuses on the quality of the projects that companies take rather than quantity.
Disadvantages
Capital rationing may also have some disadvantages. First of all, it can be effective as long as the underlying assumptions and calculations are correct. If there are any problems within them, the process can be more harmful than beneficial. It may also encourage companies to select smaller projects due to quicker returns, rather than focusing on long-term projects. The process also focuses more on the timing of returns rather than maximization of wealth.
Conclusion
Capital rationing is a part of capital budgeting. It is the process of allocating limited resourced to different projects. It can also be defined as the process of limiting investments in various projects. Typically, It occurs due to limited resources. There are two types of capital rationing, hard capital rationing and soft capital rationing. Capital rationing can also help companies select between divisible and non-divisible projects and it can be as single period capital rationing and multiple period capital rationing. The most common techniques used in capital rationing are profitability index and net present value. Its process may have certain advantages and disadvantages as well.
