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Capital Rationing

Capital rationing is a strategy employed by firms or investors to limit the number of new projects or investments it takes on, owing to a shortage of available funds. It necessitates selecting and prioritizing projects that provide the best returns within the financial restrictions, which can be either internally imposed (soft rationing) or externally imposed (hard rationing). The objective is maximize shareholder wealth by allocating limited capital to the most profitable opportunities.

Companies that used a capital rationing strategy often generate a relatively higher return on investment (ROI). This is as a result of the firm invests its resources where the highest potential is identified. 

Soft Rationing
Soft capital rationing (internal rationing) is dependent on internal policies of the firm. A fiscally conventional company, for example, may need a specifically high projected return on its capital prior to it getting involved in a project; in essence, self-imposing capital rationing. 
 
Purpose: To sustain a stable growth rate, a prevent issuing new debt or equity, or to spur competition among departments for capital. 

Hard rationing (external rationing) happens a firm incapable raise adequate capital  from external sources, namely the capital markets. 

Purpose: Poor economic conditions, firm being recognized as too risky by investors, or other external factors precluding it from borrowing 

Based on EXHIBIT 01, projects 1 and 2 offer the highest potential profit. Thus, a company or an investor is likely to invest in those two projects.

 

 

  1. Projection Evaluation: Firms estimate potential projects using metrics like the Net Present Value (NPV) or Profitability Index (PI) to ascertain their expected profitability.
  2. Project selection: Companies select the combination of projects that maximize the total NPV without exceeding the capital budget.

Divisible vs. Indivisible Projects

  1. Divisible Projects: Projects that can be partly accepted. The best method is to rank projects by their Profitability Index (PI) and the order of selection until the budget is used up.
  2. Indivisible Projects: Projects that must be accepted or rejected in their completely. Finding the optimal mix necessitates assessing all possible combinations of projects to find the one with the highest total NPV.