Definition: Capital rationing is a strategy that firms implement to place limitations on the cost of new investments. Normally, capital rationing is engaged when a firm has a low return on investment (ROI) from its current investments due to high investment costs.
What Does Capital Rationing Mean?
The main objective of capital rationing is the maximization of shareholder wealth. In this context, a firm may decide to implement capital rationing by seeking new investment opportunities with a higher net present value as well as setting a higher ceiling on the cost of capital. In doing so, the firm can assume control over its resources and undertake fewer projects or projects with a higher expected return on investment.
Let’s look at an example.
Allison is a finance manager in Company XYZ and has to determine which projects should the company undertake to maximize shareholder wealth. The total budget of the company is $10 billion and Allison has to determine the optimum product mix out of five different projects.
The initial investment and present value of each project are as follows:
- Project A: $5 million, NPV = $6 billion
- Project B: $3 million, NPV = $4 billion
- Project C: $4 million, NPV= $3 billion
- Project D: $5 million, NPV= $ 2billion
- Project E: $6 million, NPV= $5 billion
Allison has to select those projects that maximize shareholder wealth. Therefore, she calculates the profitability index of each project by dividing the NPV by the initial investment as follows:
- Project A: $6 billion/$5 million = 1.2
- Project B: $4 billion/$3 million = 1.33
- Project C: $3 billion /$4 million =0.75
- Project D: $2 billion/$5 million = 0.4
- Project E: $5 billion /$6 million = 0.83
Allison will accept the projects with the highest profitability indices up to the total budget of $10 billion. In this case, the company XYZ can invest in projects A and B, which require an initial investment of $8 billion. Project D that has an initial investment of $2 billion and could be considered for investment, has the lowest profitability index, so it may not be profitable.