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?
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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.
