Become a Financial Modeling & Valuation Analyst (FMVA)®. Enroll today to advance your career!

Capital Rationing

The process of selecting and investing in the most profitable project(s)

What is Capital Rationing?

Capital rationing is a strategy used by many companies to limit the number of projects they can take. If there is a pool of investments that are all profitable, capital rationing allows the investor or business owner to choose the most profitable investments. In short, it is assumed that the strategy will result in a high return on investment (ROI) because the company is expected to select the investment with the most potential.

 

Capital Rationing theme

 

Capital Rationing Example

Capital rationing is about putting restrictions on investments and projects taken by a business. To illustrate it better, let’s consider the following example:

Let’s say, VV Construction is looking at five projects for it to invest in, as shown below:

 

Sample Table

 

To determine which project offers the most profitability, we compute each project using the following formula:

Profitability =  NPV / Investment Capital

 

Computation

 

Based on the table above, it can be said that projects 1 and 2 are the most profitable ones. Therefore, VV Construction can invest in the two projects mentioned.

 

Types of Capital Rationing

There are basically two types of capital rationing – hard and soft capital rationing.

 

1. Hard capital rationing

It suggests that the restriction to making investments was caused by an external force, such as the investor or investors themselves. It may be due to fears that certain investments may not perform well because of a series of previous investments that didn’t return expected profits. It can also be done especially during a really tight economic time wherein most lenders and investors would want to charge high interest rates.

 

2. Soft capital rationing

Soft capital rationing is the type wherein the company itself sets the restriction on itself. It is usually done by putting less money into investing until such time that its current investments begin to perform better.

 

Why is Capital Rationing Used?

Capital rationing is used by many investors and companies in order to ensure that only the most feasible investments are taken. It helps to make sure that businesses will invest only on those projects that will give the highest returns at the projected time. It may be true that all investments with high projected returns should be taken; however, there are times when funds are low, and investors need to be selective.

 

Advantages of Capital Rationing

There are many advantages of capital rationing as seen by many investors. They include:

 

1. Sets a budget

The ability to set a budget is considered the most practical advantage of capital rationing because a certain budget or investment limit is set beforehand.

 

2. Limits the number of projects

When a company invests in too many projects, the sharing of funds will be smaller for each, and management takes more time and effort. However, with capital rationing, the number of projects are limited; thus, making it easier for owners and managers to manage the projects.

 

3. Higher returns

Even with few projects, capital rationing only allows investments with a high projected return to be taken. As a result, the returns are also high. Too many smaller investments can only waste time and money.

 

4. Better stability for the company

With taking only a few projects, the company’s coffers are not exhausted. There is still enough funding for its other activities, such as management and maintenance.

 

Disadvantages of Capital Rationing

Capital rationing also comes its own set of disadvantages, including:

 

1. High capital

Because only the most profitable investments are taken, it can also spell high capital requirements.

 

2. Goes against the efficient capital markets theory

Instead of investing in all projects that are seen to make profits, it only selects projects with the highest foreseen returns.

 

More Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Due Diligence in Project Finance
  • Incremental Cash Flow
  • Project Evaluation Review Technique (PERT)
  • Types of Budgets

Financial Analyst Training

Get world-class financial training with CFI’s online certified financial analyst training program!

Gain the confidence you need to move up the ladder in a high powered corporate finance career path.

 

Learn financial modeling and valuation in Excel the easy way, with step-by-step training.