Capital rationing

From CEOpedia | Management online

Capital rationing means that top management or other decision body limits capital for new investments undertaken by a company. It can have financial reasons, e.g. intention to keep higher liquidity or predicting other financial problems. Other reasons can be related to human resources, e.g. lack of competent project managers.

Capital rationing can be applied in two ways. The hard one is related to external problems with raising funds (e.g. company is unable to obtain loan). The soft one is related to internal decisions.

In most companies there is a limit of investments to be undertaken at the time. Some of them have to wait or to be canceled. In this day and age capital rationing is part of project portfolio management. The project management office or board of directors chooses projects that are the most important for the company or are related with the highest profits or NPV.[1].

Capital rationing is a strategy used by organizations attempting to limit the costs of their own investments. Typically, a company engaging in capital rationing has made unsuccessful investments of capital in the recent past and would like to raise the return on those investments prior to engaging in new business.

Capital rationing is a common practice in most of the companies as they have more profitable projects available for investment as compared to the capital available. In theory, there is no place for capital rationing as companies should invest in all the profitable projects. However, a majority of companies follow capital rationing as a way to isolate and pick up the best projects under the existing capital restrictions.

Hard and soft capital rationing

There are two situations which may lead to capital rationing, namely hard and soft capital rationing. Hard capital rationing or "external" rationing occurs when the company faces problems in raising funds in the external equity markets. This can lead to the shortage of capital to finance the new projects in the company.

On the other hand, soft capital rationing or "internal" rationing is caused due to the internal policies of the company. The company may voluntarily have certain restrictions that limit the number of funds available for investments in projects. However, these restrictions can be modified in the future; hence, the term ‘soft’ is used for it.

Hard capital rationing

Is an external form of capital rationing. The company finds itself in a position where it is not able to generate external funds to finance its investments.

There could be several reasons for this scenario:

  • Start-up fimrs: Generally, young start-up firms are not able to raise the funds from equity markets. This may happen despite the high projected returns or the lucrative future of the company.
  • Poor management / track record: The external funds can also be affected by the bad track record of the company or the poor management team. The lenders can consider such companies as a risky asset and may shy away from investing in projects of these companies.
  • Lender's restrictions: Quite often, medium-sized and large-sized companies rely on institutional investors and banks for most of their debt requirements. There may be restrictions and debt covenants placed by these lenders which affect the company's fund-raising strategy.
  • Industry specific factors: There could be a general downfall in the entire industry affecting the fundraising abilities of a company.

Soft capital rationing

On the other hand, is a company-led capital restriction due to the following reasons:

  • Promoter's decision: The promoters of the company may decide to limit raising more capital too soon for the fear of losing control of the company's operations. They may prefer to raise funds slowly and over a longer period to ensure their control of the company. Moreover, this could also help in getting a better valuation while raising capital in the future.
  • An increase in opportunity cost of capital: Too much leverage in the capital structure makes the company a riskier investment. This leads to an increase in the opportunity cost of capital. The companies aim to keep their solvency and liquidity ratios under control by limiting the amount of debt raised.
  • Future scenarios: The companies follow soft rationing to be ready for the opportunities available in the future, such as a project with a better rate of return or a decline in the cost of capital. There is prudence in conserving some capital for such future scenarios.
  • Single period and multi-period capital rationing: Capital rationing can be distinguished on the basis of the period of rationing too. Single period rationing is when there is a capital shortage for one period only. Profitability Index (PI) is the most popular method used in this scenario. Multi-period rationing occurs when the shortage is for more than one period. Linear programming technique is used to rank projects in multi-period rationing[2].

Why and how to ration capital

The main goal of capital rationing is to protect a company from over-investing its assets. If this were to occur, the company might continue to see low return on investment and even face a compromised financial position. Further, this can cause a company's stock to drop.

The main device for capital rationing is increasing the cost of capital. "Cost of capital" is a term used to describe the cost of debt and equity, and it can be raised or lowered based on the company's willingness to borrow money or issue stocks. A company can increase the cost of capital by borrowing less, thus making it more challenging to invest. The company would engage in new products only if the anticipated return is higher than the new cost of capital. For example, raising the cost of capital from 10 percent to 5 percent would demand the company see a 5 percent higher return on any future investment than on those in the past.

Assumptions of capital rationing

The primary assumption of capital rationing is that there are restrictions on capital expenditures either by way of ‘all internal financing’ or ‘investment budget restrictions’. Firms do not have unlimited funds available to invest in all the projects. It also assumes that capital rationing can come out with an optimal return on investment for the company whether by normal trial and error process or by implementing mathematical techniques like integer, linear or goal programming[3].

What are the benefits of capital rationing

The main benefit 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 see a good return on investments, it is wasting these resources. By capital rationing, which is the process of increasing the cost of capital, the company can make sure it takes on fewer projects. Further, it can take on only projects for which the anticipated return on investment is high. This will prevent the company from over-extending its finances, which would cause a decrease in stock price and stability.

Capital rationing to prevent bankruptcy

If you continue to invest without seeing expected payoffs, you may be doing what is commonly called chasing profits. Each dollar you earn on a future investment is simply allocated toward the gap in profits on a previous investment, putting you in a constant cycle of failing to meet returns. This can lead to bankruptcy if it goes on long enough[4].

Examples of Capital rationing

  • A company may ration its capital when it needs to make important investments, such as opening a new branch or launching a new product line, but is unable to finance the entire project. To ensure that the company can still take advantage of these opportunities, it may ration its capital and put a limit on the amount of money it is willing to spend.
  • A company may also ration its capital when it is facing a cash crunch. When the company does not have enough money to cover all of its expenses, it may ration its capital and reduce its spending on certain areas in order to conserve cash.
  • Another example of capital rationing is when a company is trying to manage its debt. In this case, the company may ration its capital by limiting how much it can borrow in order to prevent it from taking on too much debt.

Limitations of Capital rationing

Capital rationing can have some limitations:

  • It can limit the company’s growth potential - if the company is not able to invest in new projects, it will not be able to benefit from the economies of scale, innovation or other advantages that come with investing.
  • It can limit the company’s ability to compete - if the company lacks the resources to invest in new projects, it may not be able to compete with other companies in the industry.
  • It can limit the company’s ability to take advantage of new opportunities - if the company is unable to invest in new projects, it may miss out on potential growth opportunities.
  • It can limit the company’s ability to diversify - if the company cannot invest in new projects, it may be unable to diversify its portfolio, thus increasing its risk of losses.
  • It can reduce the company’s flexibility - if the company is limited in its ability to invest, it may be unable to respond quickly to changes in the market or react to new opportunities.

Other approaches related to Capital rationing

Capital rationing is an important tool used by management to allocate limited amounts of capital to a variety of projects. Other approaches related to capital rationing include:

  • Cost-benefit analysis: This approach involves analyzing the costs and benefits associated with each potential project to determine which will provide the greatest return on investment.
  • Risk-return analysis: This approach takes into account the risk associated with each project and the expected return generated by it. Projects with higher risk should have higher expected returns.
  • Opportunity cost analysis: This approach involves analyzing the opportunity costs of pursuing each project, i.e. the cost of not pursuing other investments.
  • Internal rate of return (IRR): This approach evaluates the potential return on each project by calculating its internal rate of return.
  • Return on investment (ROI): This approach evaluates each project’s potential return by calculating its return on investment.

Overall, capital rationing is an important tool used by management to allocate limited amounts of capital to a variety of projects. Different approaches can be used to evaluate the potential return of each project and to select the most profitable ones.


Capital rationing — recommended articles
Cash is king — Optimal capital structure — Bird-in-the-hand theory — Appropriation of retained earnings — Capital buffer — Defensive strategy — Free Reserves — Growth shares — Capital Base

References

Footnotes

  1. ↑ Kemp, A. G., & Stephen, L. (2014)
  2. ↑ Lumby S., Jones C.,(2003)
  3. ↑ Lorie H. J & Savage L. J.,(1955)
  4. ↑ Drury C., (2008)

Author: Iwona Maślak

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