Capital Rationing

o o 1 Capital rationing is a technique of selecting the projects that maximizes the firms 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. 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. 3. Rank them based on various criterion viz. NPV, IRR, and Profitability Index Select the projects in descending order of their profitability till the capital budget exhausts

based on each capital budgeting technique. 4. 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 Initial Cash Outflow 350 300 250 150 100 100 Ranking

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

Projects

IRR

NPV

PI

IRR

NPV

PI

A B C D E F

19% 28% 26% 20% 37% 25%

150 420 10 100 110 130

1.43 2.4 1.04 1.67 2.1 2.3

6 2 3 5 1 4

2 1 6 5 4 3

5 1 6 4 3 2

In the table, if we select based on individual method, we will arrive at following result:
IRR Projects E B C Total ICO 100 300 250 650 NPV 110 420 10 540 IRR 37% 28% 26% Projects B A Total NPV ICO 300 350 650 NPV 420 150 570 Projects B F E D Total ICO 300 100 100 150 650 PI NPV 420 130 110 100 760 PI 2.4 2.3 2.1 1.67

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.