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What is Capital Rationing, How is it Used?

  • Rudri Rawell
  • 22 Sep
  • 5 minutes

Capital rationing is a strategy adopted by companies to reduce or limit projects to be taken up within a time period. Since a company can have multiple project opportunities that may be profitable for its business, capital rationing aids in decision-making as it allows companies to prioritise the most profitable project for a given period.

Let’s understand this concept in detail.

How does capital rationing work?

Capital rationing is used by company management to appropriately allocate available funds to profitable project opportunities. It allows a company to enhance its bottom line by focusing on projects or a combination of projects that have the highest net present value (NPV) among available options.

With capital rationing, companies can ensure that they do not end up investing heavily in assets in one go. This can especially benefit companies that are unable to raise additional capital within a certain time frame.

Capital rationing decisions are often made by companies to avoid risky investments while dealing with an economic recession.

Capital rationing formats

The two broad categories of capital rationing are:

Hard rationingSoft rationing
MeaningThis format is generally imposed on a company due to existing situations that are beyond the company’s control.This is used in situations where a company has the choice of imposing certain capital usage restrictions for enhanced profitability.
ExampleAn example would be a company being unable to borrow more funds for financing new projects due to tough market conditions. An example would be a company prioritising a project due to its comparatively higher rate of return, which can help in achieving accelerated growth.

How does a company benefit from capital rationing?

Capital rationing is not just used by companies, as many investors also adopt this approach to ensure investments in the most lucrative avenues. Some of the top benefits that companies and investors can expect from capital rationing are:

  1. Better management through focus on one project

If a company takes up multiple projects in one go, all the projects will have to share the available funds. This can result in less capital availability for each project, project delays, and excessive monitoring. There may also be lower chances of success with fund allocation across multiple projects since some may end up having less funds than needed and the other way round too. 

  1. Enhanced flexibility of investment

Companies go through various business cycle phases. Accordingly, the investment opportunities also keep changing. By adopting capital rationing, a company can maintain surplus cash at hand to enjoy greater financial flexibility and enhanced stability during adverse circumstances.

It also allows companies to tap onto certain golden opportunities that may arise suddenly. This is possible only if the company has funds available instead of being allocated to various other projects. 

Drawbacks of capital rationing

Capital rationing may not work in all situations. Here are some drawbacks:

  1. Higher capital concentration

Since the theory suggests the adoption of only the most profitable projects, it can also result in higher-than-needed capital concentration on only one project or investment. This may not always be an efficient investment decision.

  1. Violates the theory of efficient capital markets

Capital rationing allows focus on only certain projects that offer the highest returns on investment. This is against the concept of the efficient markets theory that states it is practically impossible to always select investments that outperform others. 

  1. Higher risk of failure

Capital rationing can expose a company or an investor to a higher risk of failure due to concentration on only one or fewer projects/investments instead of holding a diversified portfolio. 

Conclusion

During periods of low fund availability, a company or an investor can make use of capital rationing to focus on the preservation of cash over making additional investments. It is also wise to use this strategy if there are chances of an investment with favourable terms upcoming in the near future. By employing a capital rationing strategy, companies can aim for a higher return on investment (ROI) as it allocates available resources in avenues that have the highest profit potential.

FAQs

Can capital rationing strategy be used by investors?

Yes, investors can use capital rationing to avoid over-diversification of portfolio and focus on a few investments at a time. This can help in enhancing investment profitability

What is opportunity cost of capital?

The opportunity cost of capital is the additional return on investment that a business or investor foregoes by electing to invest in a certain project instead of investing in a more profitable avenue.

Why is return on equity an important metric?

Return on equity gives an insight into an investment, or business’s profitability against the money invested. It tells investors how efficiently the company may be utilising the available equity.

Does capital rationing stall a company’s growth?

If used correctly, capital rationing enhances a company’s growth rather than stalling it. This is because it allows the company to focus on the right projects that will accelerate its growth.

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Rudri Rawell