Capital Rationing: Definition, Types and How to Calculate

Capital rationing refers to an approach used to limit the number of projects that a company or an investor should take on at any particular time. Usually there are numerous alternative investments that a company can implement to generate income; but the company cannot invest in all of them due to the scarcity of resources. Capital rationing helps the business to choose the most profitable investments and allocate the required amount of capital. Capital rationing is important for any company because it helps the company to put their money in the most profitable projects. A company that uses capital rationing will earn a higher return on investment (ROI) because it is able to invest their resources in areas that have the potential of generating the highest profits or returns.

In general, capital rationing is concerned with putting restrictions on investment projects that a business can take on at a time.

How to calculate capital rationing

To calculate capital rationing, you apply the following formula for each project:

Profitability = NPV/Investment Capital

The next step is to rank projects based on the profitability calculated using the formula above.

Example:

A company has five possible projects to invest, but it can choose only 2 projects. The NPVs and Investment Capital for the five projects are listed below:

Project Investment Capital ($) NPV ($)
1 2 billion 2 billion
2 4 billion 2 billion
3 5 billion 3 billion
4 4 billion 4 billion
5 6 billion 5 billion

Required: Determine which two projects should the company choose?

Solution:

Calculate the profitability of each project using the formula:

Profitability = NPV/Investment Capital

Project NPV/Investment Capital Profitability
1 2 billion / 2 billion 1
2 2 billion / 4 billion 0.5
3 3 billion / 5 billion 0.6
4 4 billion / 4 billion 1
5 5 billion / 6 billion 0.83

Based on the table above, the projects can be ranked as follows: 1 = 4 > 5 >3 > 2. In this regard, the company should choose project 1 and project 4 because they have the highest profitability.

Types of Capital Rationing

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

Hard Capital Rationing

Hard capital rationing is a type of rationing that is imposed to a company by factors beyond their control. For example, poor credit rating may prevent a company from borrowing funds to invest in new projects. If a company faces restrictions on access to credit for any reason, it may not be able to finance many projects. It has to limit its investments to the amount of money it has in its capital reserves or retained earnings. Another reason for hard capital rationing is when prices of inputs have risen suddenly due to unexpected inflation in the economy, which makes it difficult for the company to raise enough money to buy inputs.

Soft Capital Rationing

Soft capital rationing is a situation whereby a company chooses freely to limit its investments even if it has enough capital to do as many projects as possible. For instance, a company may decide to pursue only those projects that have a high rate of return. The company may also reduce its investment appetite to avoid taking too many risks and take a cautious approach to minimize risks.

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