What Is Capital Rationing?
Capital rationing is the process through which companies decide how to allocate their capital among different projects, given that their resources are not limitless. The main goal is to maximize the return on their investment.
- Capital rationing is a process that companies use to decide which investment opportunities make the most sense for them to pursue.
- The typical goal of capital rationing is to direct a company's limited capital resources to the projects that are likely to be the most profitable.
- Hard capital rationing refers to restraints put on a company by outside entities, such as banks or other lenders.
- Soft capital rationing results from a company's own policies relating to how it wants to use its capital.
Understanding Capital Rationing
Businesses typically face many different investment opportunities but lack the resources to pursue them all. Capital rationing is a way of allocating their available funds in a logical manner. A company will typically attempt to devote its resources to the combination of projects that offers the highest total net present value (NPV).
Companies may also use capital rationing strategically, forgoing immediate profit to invest in projects that hold out greater long-term potential for the business as it positions itself for the future.
Two Types of Capital Rationing
There are two primary types of capital rationing, referred to as hard and soft:
- Hard capital rationing. This type of capital rationing occurs based on external factors. For example, the company may be finding it difficult to raise additional capital, either through equity or debt. Or, its lenders may impose rules on how it can use its capital. These situations will limit the company's ability to invest in future projects and may even mean it must reduce spending on current ones.
- Soft capital rationing. This second type of rationing is also known as internal rationing. It is based on the internal policies of the company. A fiscally conservative company, for example, may require a particularly high projected return on its capital before it will get involved in a project—in effect, self-imposing capital rationing.
Examples of Capital Rationing
Suppose that based on its borrowing costs and other factors, ABC Corp. has set 10% as the minimum rate of return it wants from its capital investments. This is sometimes referred to as a hurdle rate.
As ABC weighs its various investment opportunities it will look at both their likely return and the amount of capital they require, ranking them according to what's known as a profitability index.
For example, if one project is expected to return 17% and another 15%, ABC may fund the 17% project first and fund the 15% one only to the extent that it has capital left over. If it still has capital available, it might then consider projects returning 14% or 13% until its capital has been fully allocated. It would be unlikely to fund a project returning below its hurdle rate unless it has other reasons for doing so, such as to comply with government requirements.
A company might also choose to hold onto its capital if can't find enough attractive investment opportunities or if it foresees difficult times ahead and wants to keep funds in reserve.
What Is the "Cost of Borrowing"?
The cost of borrowing is often expressed in terms of an effective annual interest rate, which takes into account both the simple interest rate that a lender charges and the effect of compounding. A company's cost of borrowing is based in part on its likelihood of defaulting on the debt.
How Do Companies Raise Capital?
Businesses can raise capital in several ways. They can borrow money through loans or by issuing bonds, known as debt capital. They can also raise equity capital by selling shares in the business. And they can generate their own capital in the form of retained earnings, which represents income they still have left over after meeting their other obligations, such as stockholder dividends.
What Is Working Capital?
Working capital is a measure of a company's current assets minus its liabilities. Working capital is used to meet the company's short-term financial obligations.
The Bottom Line
Companies are limited in how much capital they have available to invest in new projects at any given time. Capital rationing is a way for them to decide how to allocate their capital among those projects. The goal is typically to maximize the return on their investment, although long-term strategy and other factors can also come into play.