Capital Rationing (Meaning, Example) - Types & Assumptions

11/5/22, 4:54 PM Capital Rationing (Meaning, Example) | Types & Assumptions
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Capital Rationing
Article by Reviewed by
Ashish Kumar Srivastav Dheeraj Vaidya, CFA, FRM
What is Capital Rationing?

Capital rationing is a process or a method applied to select and allocate a
combination of project mix in a manner made of shareholder’s wealth with
limited initial investment amount available for investing in several projects
under consideration.
Table of contents
What is Capital Rationing?

Example of Capital Rationing
Types
Assumptions
Causes
Capital Rationing vs Unlimited Funds
Benefits
Limitations x
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Let us take an example to understand the concept better.


You can download this Capital Rationing Excel Template here – Capital
Rationing Excel Template
Suppose there is a company named Yuva Constructions Ltd (‘YCL’). YCL is

engaged in the business of construction of buildings for residential and
commercial purposes. It has secured the required preliminary permissions and
approvals from the state government for constructing three projects – Project
A, B, and C.
YCL has a total budget of $10 billion. Project A, B, and C are expected to yield
total value (present value of cash flows) of $7 billion, $8 billion, and $6 billion
respectively viz a viz the initial investment required for each is $5 billion, $6
billion and $5 billion respectively. Apply the capital rationing and find the
optimal combination.
Solution:
First, let’s tabulate the information provided to us for ease of reference.
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Now, YCL has $10 billion. To maximize the investors’ wealth, it will have to
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agree to
budget of $10 million. Accordingly,
our use it willPolicy)
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to find
 out the expected
rate of return for all the projects and then rank them according to

profitability index.
The below table thoroughly explains the same.
Based on the ranks, YCL must select Project A and B, as they have the
highest profitability. However, the total initial investment required if it
chooses Project A and B would exceed the available funding, i.e., it will
require $11 billion ($5 billion + $6 billion) compared to the available $10
billion.
In such a situation, it will have to discard one project and move to the next
ranking project which suits its investment needs. Thus, YCL will have the
option to go ahead with Project A and C, which will entail an investment
well within the available capital of $10 billion and will have to forego
investing in Project B.
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Types
It can be segregated based on two types. The first is known as hard rationing,
and others are referred to as soft rationing.
1. Hard Capital Rationing means when the additional capital infusion or any
restriction on the use of existing investment funding is limited by forces of
external sources.
2. Soft Capital Rationing refers to restrictions on the use of capital funding

for various projects based on restrictions imposed by management and its
decisions. x
Assumptions
Some of the assumptions are as follows.
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
The primary assumption is that there is a restriction imposed, either


through internal forces or external, on capital funding.
The other assumption followed here is that there are several projects to be
undertaken by the company or investors. Selecting certain projects will
help optimize returns for the investment made.
Lastly, the concept of capital rationing is based on the assumption that the
expected rate of return of proposed projects to be undertaken shall be
achieved as expected, thus ignoring practical factors such as economics,
politics, policies, and such.
Causes
The increased cost of capital for higher capital/funding requirements.
Higher debt in books of the company.
Any internal management restriction.
Lack of human resources or knowledge for undertaking all the projects.
Capital Rationing vs Unlimited Funds

Capital Rationing Unlimited Funds
A situation with no cap on capital/funding

A situation with fixed capital in hand and to
available and thus undertake any project
choose the projects based on profitability.
with suitable profitability.
You select the project based on ranking

You either accept or reject the project based
arrived by considering the rate of return and
on the required acceptance criterion.
fixed capital investment. x
The focus is on
Banking & Finance Videos The focus is on generating at least minimum
maximizing
Subscribe toshareholder wealth.
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There may be funds idle subscribers
applying Investors utilized all the money and make
capital rationing. investments.

Benefits
The use of capital rationing does come with its shares of advantages and
benefits for the users. Some of the benefits are as follows.
Any restriction on the use of available resources, in our case money, will
utilize the resource in the best optimal manner.
The company’s management or investors would not invest in any project

coming their way without getting into detailed analysis. This ensures there
is no wastage or unnecessary use of free funds available.
The investors would receive the highest or maximum returns on their

investments by following the optimal utilization process.
It may entail investing in only a few projects, which would help the
management put in lesser efforts in managing the affairs of the projects
and yield better results.
The company or the investor will have funds available even after investing
in the projects, thus ensuring there is no cash crunch.
Limitations
Some of the limitations are as follows.
It focuses on investing in fewer projects, which keeps the balance

shareholder funds idle.
x
The concept of capital rationing is based on the assumption that the
project&will
Banking yield aVideos
Finance particular return. Any miscalculation of the same would
result to
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the project generating lesser
Youtube Channel profits.
Projects that are

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discarding certain long-term projects,
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be
 healthy for the
company’s stability.

The evaluation process ignores any intermediate cash flows that the
project may have and the time value associated with such cash flows.
Conclusion
Capital rationing is a process of selecting a project mix that will provide the
maximum profit by investing the limited capital available in various projects.
The process is followed after considering the restrictions in place, whether
internal or external forces, for the investments to be made.
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This has been a guide to what is Capital Rationing and its meaning. Here we
discuss an example and two types (Hard and soft rationing) of capital rationing
with their assumptions, causes, and differences. You may refer to the following
articles to learn more about finance –
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11/5/22, 4:54 PM Capital Rationing (Meaning, Example) | Types & Assumptions

Home » Investment Banking Resources » Corporate Finance Resources » Capital Rationing

What is Capital Rationing?

What is Capital Rationing?

Capital Rationing vs Unlimited Funds

Let us take an example to understand the concept better.

Suppose there is a company named Yuva Constructions Ltd (‘YCL’). YCL is

First, let’s tabulate the information provided to us for ease of reference.

The below table thoroughly explains the same.

2. Soft Capital Rationing refers to restrictions on the use of capital funding

The primary assumption is that there is a restriction imposed, either

Higher debt in books of the company.

Any internal management restriction.

Lack of human resources or knowledge for undertaking all the projects.

Capital Rationing vs Unlimited Funds

A situation with no cap on capital/funding

You select the project based on ranking

The company’s management or investors would not invest in any project

The investors would receive the highest or maximum returns on their

It focuses on investing in fewer projects, which keeps the balance

Projects that are

FREE INVESTMENT BANKING COURSE

Learn the foundation of Investment banking, financial modeling,

Join Wallstreetmojo Youtube

Join Wallstreetmojo Instagram

Go to Thai, use ACLEDA

FREE FINANCE MODELING COURSE

Learn Financial Modeling in Excel with this Step by Step Guide

Go to Thai, use ACLEDA mobile

ACLEDA Bank Plc. Learn More

Join Wallstreetmojo Linkedin

Go to Thai, use ACLEDA mobile

ACLEDA Bank Plc. Learn More

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