Financial Management Concepts in Layman's Language

Capital Rationing

By on March 8, 2012 in Investment Decisions with 0 Comments

Capital rationing is a technique of selecting the projects that maximizes the firm’s value when the capital infusion is restricted. Two types of capital rationing are soft and hard capital rationing. The calculation and method prescribes arranging projects in descending order of their profitability based on IRR, NPV and PI and selecting the optimal combination.

Capital Rationing

Capital Rationing

Many a times, a firm may come across a situation when it has various profitable investment proposals. Can it take all of them for execution? Not always because most of the times there are capital restrictions. These restriction may be because of the investment policy of the firm and at the same time, it is not possible acquire unlimited capital at one cost of capital. In such a situation, finance manager would accept a combination of those projects, totaling less than the capital ceiling, to achieve maximization of wealth. This process of evaluation and selection of project is called capital rationing.

Definition of Capital Rationing

It can be defined as a process of distributing available capital among the various investment proposals in such a manner that the firm achieves maximum increase in its value.

Types of Capital Rationing

Based on the source of restriction imposed on the capital, the capital rationing is divided into two types viz. hard capital rationing and soft capital rationing.

Soft Capital Rationing: It is when the restriction is imposed by the management.

Hard Capital Rationing: It is when the capital infusion is limited by external sources.

Capital Rationing Decisions

Capital rationing decisions by managers are made to attain the optimum utilization of the available capital. It is not wrong to say that all the investments with positive NPV should be accepted but at the same time the ground reality prevails that the availability of capital is limited. The option of achieving the best is ruled out and therefore rational approach is to make most out of the on hand capital.

Capital Rationing Method

The method of capital rationing can be bifurcated in four steps. The steps are

 

1.     Evaluation of all the investment proposals using the capital budgeting techniques of Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index (PI)

2.     Rank them based on various criterion viz. NPV, IRR, and Profitability Index

3.     Select the projects in descending order of their profitability till the capital budget exhausts based on each capital budgeting technique.

4.     Compare the result of each technique with respect to total NPV and select the best out of that.

Capital Budgeting Calculation with Example

Assume that we have a following list of projects with below mentioned cash outflow and their evaluation results based on IRR, NPV and PI along with their respective rankings. The capital ceiling for investment is say 650.

Evaluation

Ranking

Projects

Initial Cash Outflow

IRR

NPV

PI

IRR

NPV

PI

A

350

19%

150

1.43

6

2

5

B

300

28%

420

2.4

2

1

1

C

250

26%

10

1.04

3

6

6

D

150

20%

100

1.67

5

5

4

E

100

37%

110

2.1

1

4

3

F

100

25%

130

2.3

4

3

2

In the table, if we select based on individual method, we will arrive at following result:

IRR

NPV

PI

Projects ICO NPV IRR Projects ICO NPV Projects ICO NPV PI
E

100

110

37%

B

300

420

B

300

420

2.4

B

300

420

28%

A

350

150

F

100

130

2.3

C

250

10

26%

Total

650

570

E

100

110

2.1

Total

650

540

D

150

100

1.67

Total

650

760

The results are quite obvious and we will go with B,F,E and D to achieve maximum value of 760.

Please note that for the sake of basic understanding, we have taken a simple example inspired by the book “Fundamentals of Financial Management” by Van Horne and Wachowicz.

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