What Is Capital Rationing? Give Example and Reason to Choose

Capital rationing is the rationing of investments & capital among various opportunities by business organizations. Capital rationing is the practical picture of capital budgeting because the financial resources available to a certain company are limited in real-life situations.

Besides organizations, countries also perform capital rationing. For example in particular country food rationing is done. The most important criterion that is used in capital rationing for making decisions about the investment in certain projects is the Net Present Value.

Moreover, the Internal Rate of Return is the second significant criterion that is used for making such a decision. Besides these criteria, there is another standard that is best used in capital rationing called Percent Budget Utilization. This standard is related to mobilizing of a percentage of total investing available money.

Those investments are considered who’s calculated IRRs are greater than the current risk-free rate of return because of the fact that it is the desire of every company to maximize its return from its portfolio. In the practical environment, the available money to any organization is limited and the company has to spend that limited portion in different investments.

Therefore the new aspect of the analysis is considered which is capital rationing for making investments in potential projects. The investment decision is made keeping in view the size & importance of the investment options. The investment decisions which are very important & essential are taken by the CEO or the company. On the other hand, normal growth and R&D related investment decisions are made by the heads of the divisions or middle management.

Reasons for Capital Rationing

In practical scenarios, different situations come in front of the company in which it has positive NPVs & higher IRRs about projects but still, it is not possible to make an investment in them. The following are some of the reasons in this regard.

• One big reason is that the potential project requires higher initial investment which is not possible for the organization in the light of its limited capital. So in such cases that potential project is rejected.
• There may be a lack of relevant human resources, talent, or knowledge for the staring or operating of the new potential project. Even in such a case, the company will not invest in that project.
• The fear of debt is another reason for the rejection of potential investment options by companies. In Muslim countries, the interest paid on debt (Riba) is considered as a major issue because of the religious constraint for Muslims in the borrowing of money on interest. Therefore in many Muslim countries, there is an ethical basis associated with capital rationing. So the investors of such Muslim countries invest in equity based projects where there is a risk of profit or loss.

Example:

The following example clearly shows how capital rationing takes place in the selection of certain investment project among groups of available options.

Suppose there are four projects (relating to real assets & are mutually exclusive) and the company has to make decisions from them in the light of its limited capital of $ 1,000.

There are four available options and a decision need to be made by management to certain projects among the pool because it is not possible for the company to start all the 4 projects because the total initial investment (I_o) of the 4 projects is equal to $ 1,400 (100+300+200+800) which is greater than the total available capital of $ 1,000. So the company adopts a capital rationing procedure which is as follows.

Option 1:

If the company decides to select projects A, B & C then it has to find out the cumulative NPV of these three projects & along with the combined IRR. Finally, a special parameter of capital rationing is considered which is the percentage of total budget available being invested if the three projects are availed.

Budget Utilization = 100+300+200 = 600 (out of 1,000)

Total NPV of the three projects = 300+200+300 = 800

Simple Average IRR = (40+35+40)/3 = 38% (non-weighted)

The combined NPV of the three projects is 800 which are better as compared to the size of investments. The average IRR of 38% is also attractive. At last the percentage of budget utilized is considered which is

Budget Utilization = 100+300+200 = 600

This means that 60% of the total budget will be utilized in this option.

Now a similar process will be applied to the second and third options.

Option 2:

In this option the company select project C & D because they have the highest combined NPV.

Budget Utilization = 200+800 = 1,000

Total NPV of the two projects = 300+600 = 900

Average IRR = (40+30)/2 = 35%

Option 3:

In this option projects, A & D are selected because they also have the highest combined NPV.

Budget Utilization = 100+800 = 900

Total NPV of the two projects = 300+600 = 900

Average IRR = (40+30)/2 = 35%

Conclusion:

The summary of the Capital Rationing Process of the above three options is as follows.

From the above summary, it is clear that option 2 is the best option among all the available three options because it has the highest NPV of $ 900 while the 100% budget is utilized. It also has an average IRR of 35%.

Reason for not choosing of Option 1

In option 1, there is the highest average IRR of 38% but it has the lowest NPV from the other two options. There is another reason for not selecting option 1 which is that the utilizing budget in this option is only 60% and there is 40% remaining amount of money which cannot be utilized in any other project & hence remain idle.

This idle money can finally be deposited into a bank account for earning a minimum return of 9 to 10% because there is no other investment option for it. So it is also clear that the percent of budget utilized is very important and it must be closest to 100% in selecting an option of investment.

Kinds of Problems in Capital Rationing

There are certain problems that are part of the capital rationing technique of Capital Budgeting. These problems are as follows.

1. Different sizes of cash flows
2. Timing difference of cash flows
3. Unequal (Different) lives of different projects

The difference in Size (In Investment Outlay)

The initial investment (or outlay) differences show different extents of the utilization of the budget. In such a case, two projects with different sizes of cash flows are compared. One project having larger cash flows occurring at a different point in time and others containing smaller cash flows at a regular interval of time.

If the cash flows of two projects are different then where will the leftover portion of the budget or un-utilized money be invested? The idle portion of the money is not able to generate any kind of return and hence go wasted.

Example:

Let’s suppose there are two projects A & B which have different sizes of cash flows. The total budget for the project is $ 1,500.

1. Project A

Cash Flows:  I_o = -$ 1,500,   year1 = +1,900

NPV = $ 227 (at i = 10%), IRR = 27%

1. Project B

Cash Flows:  I_o =- $ 200,   Year1 = $ 300

NPV = $ 73 (at i = 10%), IRR = 50%

If the above two projects are compared then it is reflected that the IRR of project B is higher than project A. But NPV is more important than IRR in comparing the potential of the investment options. The NPV of project A is greater than of project B therefore project A is the best option for investment. But at the same time, the IRR of project A is lower than project B because larger size cash flow is received at a later point of time in project A as compared to project B.

The difference in Timing:

A certain project that has good NPV can suffer from lower IRR. The reason behind this lowering of IRR is that there are larger cash flows are received at a later point in time.

Example:

Suppose there are two projects A and B having different timing of cash flows. The total budget of the project is $ 2,500

1. Project A

Cash Flows:  I_o = -$ 1,000, Year1 = +$ 650, Year2 = 650, Year3 = 650 (annuity)

NPV = +$ 616 (at i = 10%)   IRR = 43%

1. Project B

Cash Flows:  I_o = -$ 1,000, Year1 = +$ 100, Year2 = +$ 200, Year3 = +$ 2,000 (late large cash flow)

NPV = +$ 758 (at i = 10%)   IRR = 35%

When the above two projects are compared project B is the best option to select on the basis of higher NPV.

Different Lives Problem:

There is a situation where investment projects or assets have different lives. For example, there are two options for purchasing a printing machine by a business. One option is to purchase a new printing machine with a longer life span and the other option is to purchase a machine of a shorter lifespan. Each life span has its own advantage & disadvantage.

The disadvantage of Project with longer Life Span

The longer life span asset cannot be replaced quickly in order to update with the latest technology that lowers the costs & improves the quality of products.

The disadvantage of Project with Shorter Life Span

The money will be reinvested in other projects which do not have certain NPV & return which will make these projects risky. And if money is not invested in any project then it will be deposited into the bank at the minimum rate of return. For making comparisons of projects with different life spans EAA and Common Life approaches are used.