CAPITAL RATIONING

Reporter: Celestial C. Andrada

Subject: Financial Management
Instructor: Joan S. Punzalan
WHAT IS CAPITAL RATIONING?
Capital rationing is essentially a management approach
to allocating available funds across multiple investment
opportunities, increasing a company's bottom line. The
combination of projects with the highest total net present
value (NPV) is accepted by the company. The number one
goal of capital rationing is to ensure that a company does
not over-invest in assets. Without adequate rationing, a
company might start realizing decreasingly low returns on
investments and may even face financial insolvency.
TYPES OF CAPITAL RATIONING
• Hard Capital Rationing. This occurs when a company has issues raising
additional funds, either through equity or debt. The rationing arises from an
external need to reduce spending and can lead to a shortage of capital to
finance future projects. “It is when the restriction is imposed by the
management.”
• Soft Capital Rationing. This type of rationing comes about due to the
internal policies of a company. A fiscally conservative company, for
example, may have a high required return on capital in order to accept a
project, self-imposing its own capital rationing. “It is when capital infusion
is limited by external sources.”
 STEPS IN CAPITAL
RATIONING
An effective capital rationing usually consists of the following steps:
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. Rank them based on various criterion viz. NPV, IRR, and Profitability
Index
3. Select the projects in descending order of their profitability till the
capital budget exhausts based on each capital budgeting technique.
4. Compare the result of each technique with respect to total NPV and
select the best out of that.
Various Approaches to Capital
Rationing
• The internal rate of return approach is an approach to capital rationing
that involves graphing project IRRs in descending order against the total
dollar investment to determine the group of acceptable projects.
The graph that plots project IRRs in descending order against the total
dollar investment is called the investment opportunities schedule (IOS).
The problem with this technique is that it does not guarantee the
maximum dollar return to the firm.
• The net present value approach is an approach to capital rationing that is
based on the use of present values to determine the group of projects that
will maximize owners’ wealth.
It is implemented by ranking projects on the basis of IRRs and then
evaluating the present value of the benefits from each potential project to
determine the combination of projects with the highest overall present value.
• Common way to approach capital rationing problem is to use the
profitability index
PI shows which projects give “most value for your money”
PI = value of project per dollar invested
Choose project with highest PI, and keep choosing projects until your
budget runs out
Illustration 1:
In the state of capital rationing generally firms should accept several smaller
but less profitable projects to allow fuller utilisation of the capital budget
instead of accepting one large project with relatively higher yield that leaves a
portion of budget unutilized. This course of action will help the firm to
maximise profitability. The following illustration will clarify the point.
If the budgeted amount is Rs. 2,50,000 it would be worth-while to accept
projects 2 and 1 instead of project 4 although its profitability index is lower
than the projects 2 and 1.
This is for the reason of fuller utilisation of funds leading to higher net present
value, as evidenced below:

Thus sum of the net present value of projects 2 and 1 (Rs. 58,000) is higher
than that of Project 4 (Rs. 50,000). the assumption implied here is that the
unutilized part of the budget yields only that what it costs and therefore,
does not add anything to the value of the firm.
Illustration 2:
S Ltd. has Rs 10, 00,000 allocated for capital budgeting purposes.
The following proposals and ascertained profitability indexes have been determined:
Comments:
(1) On the basis of ranking on profitability index method, S Ltd. may undertake
projects 1, 3 and 5 which will result in unutilized budget of Rs 1,50,000 and will
give net present value of Rs 1,76,000. The unutilized amount of Rs 1, 50,000
cannot be invested in project 2 because profitability index of this project is less
than 1. As the projects are indivisible and there is no alternative use of the
money allocated Rs 1, 50,000 will remain unutilized.
(2) On the basis of ranking on net present value method, S Ltd. may undertake
projects 3, 4 and 5 which will fully utilize the budget and give net present value
of Rs 1, 91,000.
(3) Thus, the company is advised to follow the ranking on the basis of NPV
method and invest in projects 3, 4 and 5. By doing so, the net present value of
the cash inflows will increase by Rs 15,000 (1, 91,000 1, 76,000) and there will
be no unutilized amount.
 Illustration 3:
Assume that we have the 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 Ranking

Projects Initial Cash Outflow IRR NPV PI IRR NPV

A 350 0.19 150.00 1.43 6 2

B 300 0.28 420.00 2.40 2 1

C 250 0.26 10.00 1.04 3 6

D 150 0.20 100.00 1.67 5 5

E 100 0.37 110.00 2.10 1 4

F 100 0.25 130.00 2.30 4 3

In the table, if we select based on individual method, we will arrive at

following result:
 IRR NPV PI

Projects ICO NPV IRR Projects ICO NPV Projects ICO NPV PI

E 100 110 0.37 B 300 420 B 300 420 2.4

B 300 420 0.28 A 350 150 F 100 130 2.3

C 250 10 0.26 E 100 110 2.1

D 150 100 1.67

Total 650 540 Total 650 570 Total 650 760

The results are quite obvious and we will go with B,F,E and D to achieve
maximum value of 760.