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 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:
To determine which project offers the most profitability, we compute each project using the following formula:
Profitability = NPV / Investment Capital
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.
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