Types of Capital Rationing

As discussed in the previous article, capital rationing is a form of capital budgeting. In capital rationing we change the unlimited capital assumption of capital budgeting and we try to choose projects with the finite capital that we have on hand. This finite capital may be in the form of capital that the firm already has or it may be in the form of a decision to raise a limited amount of capital in the future. Either way, the amount of capital available at the company’s disposal for decision making is finite and it is known. There are two types of capital rationing. They have been explained in this article:

Soft Rationing

Soft rationing is when the firm itself limits the amount of capital that is going to be used for investment decisions in a given time period. This could happen because of a variety of reasons:

• The promoters may be of the opinion that if they raise too much capital too soon, they may lose control of the firm’s operations. Rather, they may want to raise capital slowly over a longer period of time and retain control. Besides if the firm is constantly demonstrating a high level of proficiency in generating returns it may get a better valuation when it raises capital in the future.

• Also, the management may be worried that if too much debt is raised it may exponentially increase the risk raising the opportunity cost of capital. Most firms have written guidelines regarding the amount of debt and capital that they plan to raise to keep their liquidity and solvency ratios intact and these guidelines are usually adhered to.

• Thirdly, many managers believe that they are taking decisions under imperfect market conditions i.e. they do not know about the opportunities available in the future. Maybe a project with a better rate of return can be found in the future or maybe the cost of capital may decline in the future. Either way, the firm must conserve some capital for the opportunities that may arise in the future. After all raising capital takes time and this may lead to a missed opportunity!

This type of rationing is called soft because it is the firm’s internal decision. They can change or modify it in the future if they think that it is in their best interest to do so.

Also, companies usually implement this kind of rationing on a department basis. From a master investment budget, departmental investment budgets are drawn and each department is asked to choose projects on the basis of funds allocated. Only in case of an extremely attractive project are the departmental restrictions on capital investments compromised.

Hard Rationing

Hard rationing, on the other hand, is the limitation on capital that is forced by factors external to the firm. This could also be due to a variety of reasons:

• For instance, a young startup firm may not be able to raise capital no matter how lucrative their project looks on paper and how high the projected returns may be.

• Even medium sized companies are dependent on banks and institutional investors for their capital as many of them are not listed on the stock exchange or do not have enough credibility to sell debt to the common people.

• Lastly, large sized companies may face restrictions by existing investors such as banks who place an upper limit on the amount of debt that can be issued before they make a loan. Such covenants are laid down to ensure that the company does not borrow excessively increasing risk and jeopardizing the investments of old lenders.

So hard rationing arises because of market imperfections and because of limitations created by external parties.