A company may, in expanding its investment, have faced investment problems, one of which requires capital rationing.
These conditions allow a company to consider the capital, and the company may not accept some investment offers. Since a company aims for profit, it will consider the possibility of gain and capital.
But what exactly is capital positioning? Why is this important in a company?
- 1 What is capital rationing?
- 1.1 Types of capital rationing
- 2 Why is capital rationing important?
- 3 Capital rationing can be explained by microeconomics
- 4 Capital rationing formula
- 5 Advantage and disadvantage
- 5.1 Advantage
- 5.2 Disadvantage
- 6 How is different from unlimited funds?
- 7 Capital rationing and capital budgeting
- 8 Final thought
What is capital rationing?
Citing from Investopedia Capital rationing, this is a condition when a company has problems with the availability of funds for investment spending.
This condition may occur for a reason, for example, there are several investment options with different potential returns. However, the existing funds are not sufficient to finance the proposed investment.
Capital rationing is one of the efforts to solve optimization problems in the industrial world. Especially the problem of optimizing the capital gains owned.
Limited capital makes the company must limit the number of investments or new projects that will be carried out. This is by setting an upper limit for a certain part of the budget. Or by budgeting a higher cost of capital for investment considerations.
Capital rationing is a management approach to allocate available funds to various investment opportunities so as to increase profits. The company will receive several projects with the highest amount of Net Present Value (NPV).
Types of capital rationing
In practice, there are two types of capital rationing that are generally recognized in financial terms. the first is hard capital rationing, and the second is soft capital rationing.
Both have differences in terms of rationing. Let’s find out more.
Hard capital rationing means
Hard capital rationing is when the company faces problems in raising additional funds. The company seeks additional funds from external sources, for example through equity or debt. This forces the company to allocate capital perfectly.
Rationalization emerged as an external need, to reduce spending, due to insufficient internal financial resources. Although this could result in a lack of capital for financing future projects.
Hard capital rationing example
For example, a company called ABCD is facing four investment project options. All of these investment project options offer positive NPV.
However, for investment needs, a total of $250,000 is required. While the ABCD company only has an investment fund of $95,000. Because the investment costs are too high, forcing the company to study more deeply and choose a project.
Of course, the company will choose the project with the highest index value, and the rationing comes from external sources, such as debt to banks or equity.
Soft capital rationing means
The basic difference between soft capital rationing and hard capital rationing is the source of funds for the rationing.
If in hard capital rationing, it prioritizes taking capital from external companies. In soft capital rationing, the allocation of rationing is prioritized internally by the company.
A company that is fiscally adequate financially, may consider a new project by sourcing from the company’s internal funds.
The reason for possible causes of soft capital rationing?
A company may prefer to do soft capital rationing for several reasons, for example:
- The company’s management is not sufficiently skilled in the new area of the project.
- The company puts more effort into limiting exposure and focusing on the profitability of a number of projects.
- The new project increases the company’s financial costs to be relatively high.
- Companies prefer not to lose control or reduce EPS by issuing shares.
- The company is more concerned with maintaining a high-interest coverage ratio.
- Companies are more concerned with limiting funds so that competing projects become more efficient.
Soft capital rationing example
ABCD company received offers for five investment projects. All of these options promise a sizable profit.
However, the company’s funds are only available for investments of $400,000. Meanwhile, if all project options are taken, it requires funds that are greater than the investment allotment funds.
Therefore, the company will choose a project that has the highest cost ratio or profitability index so that the allocation of funds does not exceed the investment limit.
- Say investment project A has an investment value of $50,000, with a profitability index of 0.90.
- Project B has an investment value of $100,000 with a profitability index of 1.00.
- Project C has an investment value of $135,000 with a profitability index of 1.32.
- #Project D has an investment value of $75,000 with a profitability index of 1.12.
- Project E has an investment value of $150.00 with a profitability index of 1.24.
Therefore, if the company takes all the options, then the company’s funds are not sufficient to cover all investment funds.
Then the company will rank each project and choose from the project with the highest profitability index value. From the example above, it is known that the project with the profitability index is projected C. Then E, D, B.
The company’s funds are only $400,000, so it will choose the profitability index ranking project which is the C, E, and D project options. Breaking down, $135,000 + $150,000 + $75,000 = $360,000.
Capital rationing solution
Broadly speaking, the solution for determining capital ratios can be:
- Reviewing investment options, including paying attention to the probability index, which is calculating the comparison of the future net cash flow value with the current investment value. Using the IRR (Internal Rate of Return) approach, Present Value (PV) or a combination of NPV and IRR.
- Create relationships between investments, whether it’s independent or dependent.
- Ranking investments is by using the ratio of benefits or costs. Or use a linear programming model.
Why is capital rationing important?
Why is capital rationing important for companies it has a purpose to benefit the company. The following reasons for the importance of capital rationing include:
- To ensure the company will not overinvest, in assets.
- Aims to ensure that the allocated funds can be used appropriately.
- Choose a group of projects that generate the highest total NPV, so that it does not require more funds than budgeted.
Capital rationing can be explained by microeconomics
Capital rationing can not only be done by companies engaged in macroeconomics. This too can be applied to microeconomics.
According to N.G Mankiew, microeconomics is a science that discusses the role of individual economic actors, how households and companies make decisions, and how they interact in certain markets.
When a company gets an investment offer in microeconomics, it can use capital rationing to increase the company’s effectiveness.
Capital rationing formula
Basically, the formula for determining the capital ratio is the first to find out the available funds in a company.
The next step is to calculate all investment offers by ranking the profitability index from the highest to the lowest.
The profitability index itself is obtained from the calculation with the formula:
NPV (Net Present Value / Investment Capital.
So let’s say a project offers an investment of $2 million and has an NPV of $2 million. Then the profitability index of the project is $2 million/$2 million = 1. The profitability index of the project is 1.
Or another example is a project that offers an investment of $5 million and has an NPV of $3 million. So the profitability index is $3 million/$5 million = 0.6.
After finding the profitability index rating, then select the project with the highest index until the company’s allocation of funds is found sufficient for investment financing.
Advantage and disadvantage
Capital rationing besides having advantages, in fact, there are also disadvantages.
When the company gets an order to invest, the allocation of funds is only for profitable projects. Or when the company gets an order to make a loan, the funds can utilize optimally for the company’s benefit.
Not all new investments will benefit the company. It will only allocate funds to projects with a high-profit index. So there is no wastage as a result of investing in each new project.
Manage fewer but potential projects
The company only allocates funds according to the budget, because the budget limitation forces the company to take only fewer projects. It will be much more efficient to manage fewer projects to focus more.
Because the company only allocates funds to projects that have a high-profit index. Most likely the project yields high returns.
The company is more stable
Capital rationing can make the company more stable and not over budget because restrictions on processes force companies to invest within the budget.
Contrary to Efficient Capital market theory
Because of restrictions on investment funds, it may violate the efficient capital market theory. Where a company should invest the projects that increase shareholder wealth.
Maybe the project cost is less profitable
Company management will adjust the budget, so you may choose a less profitable project.
NPV is not maximized
As a result of capital rationing, a company not will accept all projects. So the company cannot maximize the maximum value, so the NPV is not maximum.
Choose a small project
Company management may choose small projects because of investment restrictions, thus skipping large-scale projects.
Does not involve intermediate Cash Flow
There is no intermediate cash flow in to evaluate projects. All decisions are only on the final outcome of the project. Intermediate cash flows must in considering the time value of money.
How is different from unlimited funds?
Unlimited capital has access to capital allocation to all projects with a high return on the cost of capital. This provides more advantages than capital rationing.
Because in the capital rationing, the company has access to capital, there are restrictions on adjusting the capital budget.
Capital rationing and capital budgeting
Capital budgeting and capital rationing have different roles in a company. Budgeting only chooses which projects are feasible for investment, regardless of how much capital to invest in those projects.
It just separates out pursuing new projects that are viable and not worth investing in.
Capital rationing as described above only adjusts the budget to select the investment project with the highest index and adjusts the number of funds.
The company performs capital rationing with the aim of allocating investment in projects with a profitability index based on the highest to lowest ratings. However, in allocating capital by adjusting the number of funds available by the company.
Resources from various sources.
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