# What is Capital Rationing?

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.

## 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.