Capital rationing requires a firm to select the feasible collection of projects that creates the greatest total NPV when funding or another resource is limited.
Why capital rationing occurs
A business may identify more positive-NPV projects than it can finance. The restriction can arise from external financing conditions, internal policy, management capacity, specialist labour or other scarce resources.
Hard and soft capital rationing
| Type | Meaning | Typical cause |
|---|---|---|
| Hard rationing | Funding cannot be obtained on acceptable terms | Capital-market constraints, lender limits |
| Soft rationing | Management voluntarily limits investment | Budget control, risk limits, implementation capacity |
The correct decision objective
Accepting projects in isolation is not enough. The objective is to maximise the combined NPV of the selected portfolio while satisfying every binding constraint.
One-period decision process
- Identify incremental, after-tax cash flows.
- Reject projects with negative NPV.
- Calculate the scarce-resource requirement.
- Use PI as an initial efficiency ranking where appropriate.
- Compare feasible combinations.
- Test strategic, risk and dependency constraints.
Worked portfolio example
| Project | Investment | NPV | PI |
|---|---|---|---|
| P | 70,000 | 21,000 | 1.30 |
| Q | 50,000 | 14,000 | 1.28 |
| R | 40,000 | 10,000 | 1.25 |
| S | 30,000 | 6,000 | 1.20 |
With a 100,000 budget, P + S creates NPV of 27,000. Q + R creates NPV of 24,000, while Q + S creates 20,000. Even though Q ranks above S, the best feasible combination among these choices is P + S.
Multi-period constraints
A project selected now can change cash available in later periods. A one-year ranking may therefore block a valuable future project. Multi-period models should include each period's resource constraint and the timing of project cash flows.
Managers should also distinguish a financing limit from an implementation limit. More borrowing may solve a cash constraint, but it cannot automatically create technical staff, factory capacity or regulatory approval. The model should represent the resource that is genuinely scarce.
Indivisible, dependent and exclusive projects
Indivisible projects cannot be partially accepted. Dependent projects must be evaluated together, while mutually exclusive alternatives require a choice. These relationships must be built into the portfolio analysis.
Management checklist
- Define every scarce resource and period.
- Preserve NPV as the value objective.
- Test combinations rather than relying only on rankings.
- Document strategic dependencies and execution capacity.
- Review rejected positive-NPV projects when constraints change.
Frequently asked questions
Does capital rationing mean projects are unprofitable?
No. It means some positive-NPV projects cannot be selected because a resource is limited.
What is the main objective?
Maximise the total NPV of the feasible portfolio.
When is PI useful?
It is useful as an initial ranking under a simple, single-period constraint.
Why compare combinations?
Project sizes and relationships can make the mechanical ranking produce a lower total NPV.
Continue learning
- Using PI in capital rationing
- Limitations of PI
- Investment appraisal methods
- Risk analysis in capital budgeting
Use the formulas and examples as learning tools. Real decisions should use reliable data, appropriate assumptions and professional judgment where necessary.
Firms may have to choose among profitable investment opportunities because of the limited financial resources. In this article we shall discuss the methods of solving the capital budgeting problems under capital rationing. We shall show that the net present value (NPV) is the most valid section rule even under the capital rationing situations.
A firm should accept all investment projects with positive net present value (NPV) in order to maximize the wealth of shareholders. The net present value (NPV) rule tells us to spend funds in the projects until the net present value (NPV) of the last project is zero.
Capital rationing refers to a situation where the firm is constrained for external, or self imposed, reasons to obtain necessary funds to invest in all investment projects with positive net present value (NPV). Under capital rationing, the management has not simply to determine the profitable investment opportunities, but it has also to decide to obtain that combination of the profitable projects which yields highest net present value (NPV) within the available funds.
Why capital rationing?
Capital rationing may rise due to external factors or internal constraints imposed by the management. Thus there are two types of capital rationing.
- External capital rationing
- Internal capital rationing
External capital rationing
External capital rationing mainly occurs on account of the imperfections in capital markets. Imperfections may be caused by deficiencies in market information, or by rigidities of attitude that hamper the free flow of capital. The net present value (NPV) rule will not work if shareholders do not have access to the capital markets. Imperfections in capital markets alone do not invalidate use of the net present value (NPV) rule. In reality, we will have very few situations where capital markets do not exist for shareholders.
Internal capital rationing
Internal capital rationing is caused by self imposed restrictions by the management. Various types of constraints may be imposed. For example, it may be decide not to obtain additional funds by incurring debt. This may be a part of the firm’s conservative financial policy.
Management may fix an arbitrary limit to the amount of funds to be invested by the divisional managers. Sometimes management may resort to capital rationing by requiring a minimum rate of return higher than the cost of capital. Whatever, may be the type of restrictions, the implication is that some of the profitable projects will have to be forgone because of the lack of funds. However, the net present value (NPV) rule will work since shareholders can borrow or lend in the capital markets.
It is quite difficult sometimes justify the internal capital rationing. But generally it is used as a means of financial controls. In a divisional set up, the divisional managers may overstate their investment requirements. One way of forcing them to carefully assess their investment opportunities and set priorities is to put upper limits to their capital expenditures. Similarly, a company may put investment limits if it finds itself incapable of coping with the strains and organizational problems of a fast growth.
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