Capital Rationing: Definition, Types & Example

Instructor: Mark Koscinski

Mark has a doctorate from Drew University and teaches accounting classes. He is a writer, editor and has experience in public and private accounting.

In this lesson, you will learn about two types of capital rationing and how to rank projects when your company is subject to rationing. We'll discuss the importance of knowing the profitability index and how to apply it in these situations.

Picking Projects Using Capital Rationing

You own a small manufacturing business. Recently, sales have been very good. Your sales force reports there are profitable opportunities if you can branch out into several new product lines. Each requires an investment in new equipment, and they all have a different potential for profit. How do you decide which of these projects to invest in, if any?

The Problem of Capital Rationing

If you had your way, you would consider investing in all the projects since they could all generate a profit. Your company is still relatively small and you are unsure if you can obtain the necessary financing. This is the problem of capital rationing. Wants and needs must be weighed and measured when there is a scarcity of resources. Businesses face this challenge all the time.

Types of Capital Rationing

There are two types of capital rationing: soft rationing and hard rationing. Soft rationing is a self-imposed restraint on capital spending. There are many reasons why you would impose soft rationing on your business. Risk is just one possible reason, since any capital investment incurs risk. Any project can potentially fail, resulting in a loss. Perhaps you do not wish to expose your business to a higher degree of risk than it already has.

Hard rationing results from external constraints. A very common example of hard rationing is capital expenditure limitations imposed by lenders upon borrowers. This usually comes in the form of a covenant in the lending documents. The bank does not want the borrower to take on any more risk than what it has already agreed to. Let's assume you borrow one million dollars from the bank. They may prohibit you from making capital expenditures in excess of $1.5 million, for example. Any capital investments over this limit would result in a violation of the loan contract and might result in a loan default.

Ranking Projects

Assume your management has identified four worthwhile projects totaling $3.3 million. Your loan documents indicate only $1.5 million in capital investments can be made for the year. How do you decide which projects to green-light and which projects to reject? Fortunately, there are some guidelines and tools that can help with the decision-making process.

First, any projects required for safety purposes and by government regulation must rise to the top of the potential project list. Safety is not only good business, but it is also your responsibility to provide employees and coworkers with a safe workplace. Not abiding by government regulation can often result in large fines or even a shutdown. Clearly, these are risks no one wishes to take. Suppose in our case new safety equipment requires an expenditure of $200,000, resulting in only an additional $1.3 million of allowed capital expenditures.

The Profitability Index

The next step is to calculate the profitability index of each project. The profitability index is the present value of a project's future cash flows without regard to the cost of the project divided by the investment in the project. A project with a profitability index of 1 indicates the project is a break-even project. A profitability index of less than one means the project will lose money. Only those projects with a profitability index greater than 1 should be considered. The higher the profitability index, the more desirable the project becomes. The projects are then ranked according to the profitability index and are undertaken until the capital budget is exhausted. The goal is to maximize the total present value of the projects subject to your capital constraint.

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