Capital rationing is a technique used in capital budgeting that helps select the most profitable capital projects when the ability of a company to raise additional capital is limited, and a company sets a capital budget ceiling for the budgeting period. This technique allows a company to choose projects with maximum total net present value (NPV) and therefore maximize shareholder value in the long run.
Capital rationing occurs when the ability of a company to raise additional capital is not enough to meet the amount of investment required by the optimal capital budget!
If a company could raise unlimited funds, it would have to undertake all capital projects having positive net present value (NPV). Such a capital budgeting decision is optimal because it allows shareholder value to be maximized in the long run.
In the real world, however, a company cannot raise infinite funds because the capacity of the capital market is limited. This is the primary factor why capital rationing may arise.
Thus, the objective of the management of a company is to achieve maximum increase of shareholder value when there are capital budget constraints.
There are two types of capital rationing
Hard capital rationing occurs when external factors force a company to cut expenses, including capital expenditures. For example, creditors may include provisions in an agreement limiting borrowers’ spending to reduce the risk of default. Many companies are also forced to reduce spending when they are going to raise additional capital by issuing new debt or equity. The objective of such a strategy is to increase the free cash flow and therefore make a company more attractive to investors. As we can see, external factors may cause severe constraints on the capital budget.
Soft capital rationing is caused by internal factors. For example, to reduce overall risk, the board of directors may set a minimum internal rate (IRR) of return for capital projects. All projects having a lower IRR will be rejected even though they have a positive net present value. Dividend policy can also cause soft rationing. For example, if a company declares paying a fixed dividend per share, any failure will be negatively perceived by the market and will most likely result in a decrease in the stock price. That is why company management would prefer to cut capital expenditures than dividends.
Let’s assume that management of Tristan Inc. is preparing the capital budget for the next financial year. Ten capital projects are under consideration.
The board of directors of Tristan Inc. has set a capital budget ceiling of $100,000,000.
If Tristan Inc. could raise additional funds of $164,800,000, all ten projects should be undertaken because all of them have positive NPV. This would increase shareholder value by $159,600,000. So far as a budget ceiling is set, capital rationing occurs.
Thus, the primary goal of management is to select projects having maximum total NPV, while their total initial cost should not exceed $100,000,000.
It would be reasonable to use such a ratio as the profitability index (PI) that measures the dollar amount of the present value of expected cash flows per $1 of initial cost. For example, the profitability index of Project A is calculated as follows:
|PI of Project A =||$10,400,000 + $5,400,000||= 2.93|
Now we can arrange the list of projects in descending order of PI and add the “cumulative cost” column.
The capital budget ceiling allows the company to undertake Projects A, D, E, I, and H because they provide a higher amount of NPV per $1 of initial cost than the other projects. Undertaking Project G will exceed the limit of $100,000,000.
However, the total initial cost of Projects A, D, E, I, and H is $82,700,000, so the remaining $17,300,000 ($100,000,000-$82,700,000) remains unused. Therefore, management should use all funds available to maximize the total net present value. Let’s consider two possible scenarios.
Under both scenarios, the total initial cost and total NPV will be as follows:
Total initial cost under Scenario A = $5,400,000 + $26,500,000 + $28,700,000 + $16,000,000 + $22,200,000 = $98,800,000
Total NPV under Scenario A = $10,400,000 + $39,700,000 + $34,000,000 + $18,100,000 + $18,200,000 = $120,400,000
Total initial cost under Scenario B = $5,400,000 + $26,500,000 + $28,700,000 + $16,000,000 + $6,100,000 + $15,700,000 = $98,400,000
Total NPV under Scenario B = $10,400,000 + $39,700,000 + $34,000,000 + $18,100,000 + $6,800,000 + $12,600,000 = $121,600,000
As we can see, the initial cost under both scenarios does not exceed the limit of $100,000,000, but the total NPV under Scenario B reaches $121,600,000, which is higher than under Scenario A. This simple example illustrates how capital rationing may affect capital budgeting decisions.
In the real world, capital rationing may be much more complicated than is shown in the example above. If company management prepares capital budgets for several budgeting periods with numerous projects under consideration, special programming techniques should be applied to choose the scenario that maximizes the total net present value.