Capital Rationing Meaning, Advantages, Disadvantages, Practical Problems

13th October 2021 0 By indiafreenotes

Capital Rationing is a strategy used by companies or investors to limit the number of projects they take on at a time. If there is a pool of available investments that are all expected to be profitable, capital rationing helps the investor or business owner choose the most profitable ones to pursue.

Companies that employ a capital rationing strategy typically produce a relatively higher return on investment (ROI). This is simply because the company invests its resources where it identifies the highest profit potential.

Types of Capital Rationing

Soft capital rationing

In contrast, soft capital rationing refers to a situation where a company has freely chosen to impose some restrictions on its capital expenditures, even though it may have the ability to make much higher capital investments than it chooses to. The company may choose from any of a number of methods for imposing investment restrictions on itself. For example, it may temporarily require that a project offer a higher rate of return than is usually required in order for the company to consider pursuing it. Or the company may simply impose a limit on the number of new projects that it will take on during the next 12 months.

Hard capital rationing

Hard capital rationing represents rationing that is being imposed on a company by circumstances beyond its control. For example, a company may be restricted from borrowing money to finance new projects because it has suffered a downgrade in its credit rating. Thus, it may be difficult or effectively impossible for the company to secure financing, or it may only be able to do so at exorbitant interest rates.

Advantages:

More Stability

As the company is not investing in every project, the finances are not over-extended. This helps in having adequate finances for tough times and ensures more stability and an increase in the stock price of the company.

Fewer Projects

Capital rationing ensures that less number of projects are selected by imposing capital restrictions. This helps in keeping the number of active projects to a minimum and thus manage them well.

Budget

The first and important advantage is that capital rationing introduces a sense of strict budgeting of the corporate resources of a company. Whenever there is an injunction of capital in the form of more borrowings or stock issuance capital, the resources are properly handled and invested in profitable projects.

Higher Returns

Through capital rationing, companies invest only in projects where the expected return is high, thus eliminating projects with lower returns on capital.

No Wastage

Capital rationing prevents wastage of resources by not investing in each new project available for investment.

Disadvantages

Intermediate Cash Flows

Capital rationing does not add intermediate cash flows from a project while evaluating the projects. It bases its decision only on the final returns from the project. Intermediate cash flows should be considered in keeping the time value of money in mind.

Un-Maximizing Value

Capital rationing does not allow for maximizing the maximum value creation as all profitable projects are not accepted and thus, the NPV is not maximized.

Efficient Capital Markets

Under efficient capital markets theory, all the projects that add to company’s value and increase shareholders’ wealth should be invested in. However, by following capital rationing and investing in only certain projects, this theory is violated.

Small Projects

Capital rationing may lead to the selection of small projects rather than larger-scale investments.

Cost of Capital

In addition to limits on budget, capital rationing also places selective criteria on the cost of capital of shortlisted projects. However, to follow this restriction, a firm has to be very accurate in calculating the cost of capital. Any miscalculation could result in selecting a less profitable project.