Capital rationing is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a budget. Companies may want to implement capital rationing in situations where past returns of an investment were lower than expected.
Breaking Down Capital Rationing
Capital rationing is essentially a management approach to allocating available funds across multiple investment opportunities, increasing a company's bottom line. The company accepts the combination of projects with the highest total net present value (NPV). 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.
Two Types of Capital Rationing
The first type of capital, rationing, is referred to as "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.
The second type of rationing is called "soft capital rationing," or internal 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 to accept a project, self-imposing its own capital rationing.
Examples of Capital Rationing
For example, suppose ABC Corp. has a cost of capital of 10% but that the company has undertaken too many projects, many of which are incomplete. This causes the company's actual return on investment to drop well below the 10% level. As a result, management decides to place a cap on the number of new projects by raising the cost of capital for these new projects to 15%. Starting fewer new projects would give the company more time and resources to complete existing projects.
Capital rationing affects a company's bottom line and dictates the amount it can pay out in dividends and reward shareholders. Using a real-world example, Cummins, Inc., a publicly-traded company that provides natural gas engines and related technologies, needs to be very cognizant of its capital rationing and how it affects its share price. As of March 2016, the company's board of directors has decided to allocate its capital in such a way that it provides investors with a dividend yield near 4%.
The company has rationed its capital so that its existing investments allow it to pay out increasing dividends to its shareholders over the long-term. However, shareholders have come to expect increasing dividend payouts, and any reduction in dividends can hurt its share price. Therefore, the company needs to ration its capital and invest in projects efficiently, so it increases its bottom line, allowing it to either increase its dividend yield or increase its actual dividend per share.