Capital RationingExplained with Journal Entry Examples

Written By:
Lisa Borga

What is Capital Rationing?

Capital rationing is an investment approach that reduces the scope of new investments that a business wants to make.

This can be done by making the cost of capital higher for investments or by imposing a price ceiling on certain parts of their budget.

This strategy tends to reduce the number of projects a business gets involved in.

The strategy can be quite useful when a business needs to choose investments from a group of investments, all of which are expected to make a profit.

Capital rationing can help businesses or investors choose the investments that are most profitable.

Businesses that use capital rationing generally make a somewhat higher ROI (return on investment).

This happens because businesses using this strategy choose investments or projects with the best potential profit.

Example of Capital Rationing

Capital rationing is a strategy that involves restricting which projects and investments the business can make.

An example of this would-be ABC Glass Inc.

They have four projects they could choose to invest in, and these are shown in the following table.

Next, the profitability of each project will be calculated to find out which project is most profitable.

The equation for determining the profit is:

Profitability =  Net Present Value / Investment Capital

By using this equation, it can be seen that projects A and C give the highest potential profits.

So, ABC Glass Inc. would likely choose to invest in these projects.

The Two Kinds of Capital Rationing

Hard and soft capital rationing are the two different kinds of capital rationing.

Hard Capital Rationing

Hard capital rationing is imposed on a company.

The company is forced into this type of rationing and has no control over it.

This often occurs as a result of a company being unable to generate funds.

An example of this could be a company being unable to borrow money due to a poor credit rating.

Soft Capital Rationing

With soft capital rationing, the company has chosen to place limits on its capital investments, even when the company could be making higher capital investments.

The company might have a number of methods it can choose from for doing this.

The company might require that an investment have a higher rate of return than it would typically require before the business would consider choosing the project.

It could also choose to limit the number of projects it will consider taking on in the next year.

Why Companies Use Capital Rationing

One of the main reasons businesses and investors use capital rationing is to make sure that they only make investments that are likely to succeed.

It is also a way of ensuring that a business only invests in projects with the highest rates of return.

It is easy to believe that any project with a high projected rate of return should be taken.

But, sometimes, this is not possible due to a lack of funds.

Also, there are times when an individual or business may want to make sure they have better cash flows before they choose to make more investments.

They also may think that if they wait for a bit, they will get better terms.

An example of this would be an investor or business that chooses to wait until later to invest because they believe interest rates will be dropping, which would lower the cost of financing.

There are some other reasons for capital rationing, which we will discuss next.

Having Fewer Projects Makes Management Easier

If a business decides to invest in a large number of projects, it could actually mean there will be less money available for any one project.

Then, if this happens, managers will likely need to spend more effort and time monitoring and managing their projects.

Additionally, when projects are forced to share resources, it can make them less likely to succeed.

This could happen if it is found that one of the projects is going to need a lot more capital than was previously expected.

If a company uses capital rationing in the correct way, this type of situation can be avoided.

Businesses Using Capital Rationing May Have More Investment Flexibility

Investment opportunities tend to change frequently.

Therefore, portfolio managers often prefer to keep a lot of the funds they have available for investments in cash.

This helps these managers to keep the business more financially stable and allows the business to react to adverse circumstances.

Also, if a company keeps sufficient money around, it can take advantage of good investment opportunities that arise.

This can be important as some investment opportunities can come up quickly with little time to take advantage of them.

Possible Disadvantages of Capital Rationing

Although capital rationing can be very beneficial for companies in some situations, it does have some disadvantages as well, such as:

• Large Requirements for Capital: Due to the fact that only very profitable investments are chosen by companies using capital rationing, it can require large amounts of capital.
• Does Not Follow the Theory of Efficient Capital Markets: The efficient markets theory states that it is nearly impossible to always select investments that do significantly better than other investments. But, when companies use capital rationing, they only select investments with the highest returns. Therefore, by not having a portfolio that is adequately diversified, businesses using capital rationing may be exposed to more risk than they would with a diversified portfolio.