Capital rationing is the strategy of picking up the most profitable projects to invest the available
funds. Hard capital rationing and soft capital rationing are two different types of capital rationing
practices applied during capital restrictions faced by a company in its capital budgeting process.
In the efficient capital markets, a company’s aim is to maximize the shareholder’s wealth and its
value by investing in all profitable projects. However, in real life, a company may realize that the
internal and the external funds available for new investments may be limited.
Definition of Hard and Soft Capital Rationing
There are two situations which may lead to capital rationing, namely hard and soft capital
rationing. Hard capital rationing or “external” rationing occurs when the company faces problems
in raising funds in the external equity markets. This can lead to the shortage of capital to finance
the new projects in the company.
On the other hand, soft capital rationing or “internal” rationing is caused due to the internal policies
of the company. The company may voluntarily have certain restrictions that limit the number of
funds available for investments in projects. However, these restrictions can be modified in the
future; hence, the term ‘soft’ is used for it.
Assumptions of Capital Rationing
The primary assumption of capital rationing is that there are restrictions on capital expenditures
either by way of ‘all internal financing’ or ‘investment budget restrictions’. Firms do not have
unlimited funds available to invest in all the projects. It also assumes that capital rationing can
come out with an optimal return on investment for the company whether by normal trial and error
process or by implementing mathematical techniques like integer, linear or goal programming.
Reasons for Hard Capital Rationing
Hard capital rationing is an external form of capital rationing. The company finds itself in a
position where it is not able to generate external funds to finance its investments.
There could be several reasons for this scenario:
Start-up Firms
Generally, young start-up firms are not able to raise the funds from equity markets. This may
happen despite the high projected returns or the lucrative future of the company.
Poor Management / Track Record
The external funds can also be affected by the bad track record of the company or the poor
management team. The lenders can consider such companies as a risky asset and may shy away
from investing in projects of these companies.
Lender’s Restrictions
Quite often, medium-sized and large-sized companies rely on institutional investors and banks for
most of their debt requirements. There may be restrictions and debt covenants placed by these
lenders which affect the company’s fund-raising strategy.
Industry Specific Factors
There could be a general downfall in the entire industry affecting the fundraising abilities of a
company.
Reasons for Soft Capital Rationing
Soft capital rationing, on the other hand, is a company-led capital restriction due to the following
reasons:
Promoters’ Decision
The promoters of the company may decide to limit raising more capital too soon for the fear of
losing control of the company’s operations. They may prefer to raise funds slowly and over a
longer period to ensure their control of the company. Moreover, this could also help in getting a
better valuation while raising capital in the future.
An increase in Opportunity Cost of Capital
Too much leverage in the capital structure makes the company a riskier investment. This leads to
an increase in the opportunity cost of capital. The companies aim to keep their solvency and
liquidity ratios under control by limiting the amount of debt raised.
Future Scenarios
The companies follow soft rationing to be ready for the opportunities available in the future, such
as a project with a better rate of return or a decline in the cost of capital. There is prudence in
conserving some capital for such future scenarios.
Single Period and Multi-Period Capital Rationing
Capital rationing can be distinguished on the basis of the period of rationing too. Single period
rationing is when there is a capital shortage for one period only. Profitability Index (PI) is the most
popular method used in this scenario. Multi-period rationing occurs when the shortage is for more
than one period. Linear programming technique is used to rank projects in multi-period rationing.
Conclusion
Though the capital rationing seems to contradict maximizing shareholder wealth, it is a very
important process of the budgeting process of a company. Depending on the type of capital
rationing, the company can decide on the techniques for analyzing the investments
Advantages of Capital Rationing
Capital rationing is a very prevalent situation in companies. There are a few advantages of
practicing capital rationing:
Budget
The first and important advantage is that capital rationing introduces a sense of strict budgeting of
the corporate resources of a company. Whenever there is an injunction of capital in the form of
more borrowings or stock issuance capital, the resources are properly handled and invested in
profitable projects.
No Wastage
Capital rationing prevents wastage of resources by not investing in each new project available for
investment.
Fewer Projects
Capital rationing ensures that less number of projects are selected by imposing capital restrictions.
This helps in keeping the number of active projects to a minimum and thus manage them well.
Higher Returns
Through capital rationing, companies invest only in projects where the expected return is high,
thus eliminating projects with lower returns on capital.
More Stability
As the company is not investing in every project, the finances are not over-extended. This helps in
having adequate finances for tough times and ensures more stability and an increase in the stock
price of the company.
Disadvantages of Capital Rationing
Capital rationing comes with its own set of disadvantages as well. Let us describe the problems
that rationing can lead to:
Efficient Capital Markets
Under efficient capital markets theory, all the projects that add to company’s value and increase
shareholders’ wealth should be invested in. However, by following capital rationing and investing
in only certain projects, this theory is violated.
The cost of Capital
In addition to limits on budget, capital rationing also places selective criteria on the cost of capital
of shortlisted projects. However, to follow this restriction, a firm has to be very accurate in
calculating the cost of capital. Any miscalculation could result in selecting a less profitable project.
Un-Maximizing Value
Capital rationing does not allow for maximizing the maximum value creation as all profitable
projects are not accepted and thus, the NPV is not maximized.
Small Projects
Capital rationing may lead to the selection of small projects rather than larger-scale investments.
Intermediate Cash Flows
Capital rationing does not add intermediate cash flows from a project while evaluating the projects.
It bases its decision only on the final returns from the project. Intermediate cash flows should be
considered in keeping the time value of money in mind.
Conclusion
Though capital rationing has few disadvantages, it is still followed widely in selecting investment
projects. A company should decide on following capital rationing after studying the implications
in details.
Definition
The investment opportunity schedule is a list of projects arranged in descending order of internal
rate of return. As the main objective of a company’s management is to maximize shareholder
value, projects with the highest expected return should be undertaken first.
During each financial year, a company may have many investment opportunities, but the more
projects undertaken, the more additional capital has to be raised. In turn, raising additional capital
is quite complicated for several reasons.
1. Marginal cost of capital. The more additional capital a company is raising, the higher its
cost will be, and the higher the cost of capital, the lower the net present value (NPV) of a
project.
2. Capital markets limits. A company cannot raise an infinite amount of capital. In the real
world, a limited number of investors will be found, and a finite amount of capital can be
raised in a certain period of time.
Preparing an investment opportunity schedule allows prioritization of projects to be undertaken,
which maximizes shareholder value.
Example
The management of a company is considering seven projects of the same risk to undertake in the
next financial year.
How to make an investment opportunity schedule
Making an investment opportunity schedule involves two easy steps.
1. Arrange projects by the internal rate of return (IRR) from highest to lowest.
2. Calculate the cumulative cost (total need in additional capital).
As the net present value is the primary screening criterion, a company should accept all projects
having positive NPV. In turn, a project has a positive NPV if its IRR is higher than the cost of
capital. For example, if a company is able to raise $30,000,000 at a 12.00% interest rate, Project
D and Project A should be rejected.
If a company can raise only $5,000,000 at a 12.00% interest rate, the highest priority projects
should be undertaken, i.e., Project B and Project E.
As we can see, the investment opportunity schedule is a powerful tool in capital budgeting
decisions, which helps maximize shareholder value.
Graph
An investment opportunity schedule plotted on a graph shows how much money a company can
invest in projects of different internal rates of return. An example is shown in the figure below.
Marginal cost of capital and optimal capital budget
The investment opportunity schedule and marginal cost of capital (MCC) are very important
concepts in capital budgeting decision-making. The MCC and IRR curves should be plotted in the
same graph as illustrated in the figure below.
The optimal capital budget occurs when the IRR curve intersects the MCC curve. A company will
maximize shareholder value if such an amount of additional capital is raised and invested.
What Is Sensitivity Analysis?
A sensitivity analysis determines how different values of an independent variable affect a
particular dependent variable under a given set of assumptions. This technique is used within
specific boundaries that depend on one or more input variables.
Sensitivity analysis is used in the business world and in the field of economics. It is commonly
used by financial analysts and economists, and is also known as a what-if analysis.
Key Takeaways
sensitivity analysis determines how different values of an independent variable affect a
particular dependent variable under a given set of assumptions.
model is also referred to as a what-if or simulation analysis.
sed to help make predictions in the share prices of publicly-traded
companies or how interest rates affect bond prices.
Sensitivity analysis is also referred to as "what-if" or simulation analysis and is a way to predict
the outcome of a decision given a certain range of variables. By creating a given set of variables,
an analyst can determine how changes in one variable affect the outcome.
How Sensitivity Analysis Works
Sensitivity analysis is a financial model that determines how target variables are affected based on
changes in other variables known as input variables. This model is also referred to as a what-if or
simulation analysis. It is a way to predict the outcome of a decision given a certain range of
variables. By creating a given set of variables, an analyst can determine how changes in one
variable affect the outcome.
Both the target and input—or independent and dependent—variables are fully analyzed when
sensitivity analysis is conducted. The person doing the analysis looks at how the variables move
as well as how the target is affected by the input variable.
Sensitivity analysis can be used to help make predictions in the share prices of public companies.
Some of the variables that affect stock prices include company earnings, the number of shares
outstanding, the debt-to-equity ratios (D/E), and the number of competitors in the industry. The
analysis can be refined about future stock prices by making different assumptions or adding
different variables. This model can also be used to determine the effect that changes in interest
rates have on bond prices. In this case, the interest rates are the independent variable, while bond
prices are the dependent variable.
What Is Scenario Analysis?
Scenario analysis is the process of estimating the expected value of a portfolio after a given period
of time, assuming specific changes in the values of the portfolio's securities or key factors take
place, such as a change in the interest rate. Scenario analysis is commonly used to estimate changes
to a portfolio's value in response to an unfavorable event and may be used to examine a theoretical
worst-case scenario.
How Scenario Analysis Works
As a technique, scenario analysis involves computing different reinvestment rates for expected
returns that are reinvested within the investment horizon. Based on mathematical and statistical
principles, scenario analysis provides a process to estimate shifts in the value of a portfolio, based
on the occurrence of different situations, referred to as scenarios, following the principles of "what
if" analysis.
These assessments can be used to examine the amount of risk present within a given investment
as related to a variety of potential events, ranging from highly probable to highly improbable.
Depending on the results of the analysis, an investor can determine if the level of risk present falls
within his comfort zone.
One type of scenario analysis that looks specifically at worst-case scenarios is stress testing. Stress
testing is often employed using a computer simulation technique to test the resilience of institutions
and investment portfolios against possible future critical situations. Such testing is customarily
used by the financial industry to help gauge investment risk and the adequacy of assets, as well as
to help evaluate internal processes and controls. In recent years, regulators have also required
financial institutions to carry out stress tests to ensure their capital holdings and other assets are
adequate.
Key Takeaways
Scenario analysis is the process of estimating the expected value of a portfolio after a given
change in the values of key factors take place.
Both likely scenarios and unlikely worst-case events can be tested in this fashion—often
relying on computer simulations.
Scenario analysis can apply to investment strategy as well as corporate finance.
Special Considerations
Scenario Analysis and Investment Strategy
There are many different ways to approach scenario analysis. A common method is to determine
the standard deviation of daily or monthly security returns and then compute what value is
expected for the portfolio if each security generates returns that are two or three standard deviations
above and below the average return. This way, an analyst can have a reasonable amount of
certainty regarding the change in the value of a portfolio during a given time period, by simulating
these extremes.
Scenarios being considered can relate to a single variable, such as the relative success or failure of
a new product launch, or a combination of factors, such as the results of the product launch
combined with possible changes in the activities of competitor businesses. The goal is to analyze
the results of the more extreme outcomes to determine investment strategy.
Scenario Analysis in Personal and Corporate Finance
The same process used for examining potential investment scenarios can be applied to various
other financial situations in order to examine value shifts based on theoretical scenarios. On the
consumer side, a person can use scenario analysis to examine the different financial outcomes of
purchasing an item on credit, as opposed to saving the funds for a cash purchase. Additionally, a
person can look at the various financial changes that may occur when deciding whether to accept
a new job offer.
Businesses can use scenario analysis to analyze the potential financial outcomes of certain
decisions, such as selecting one of two facilities or storefronts from which the business could
operate. This could include considerations such as the difference in rent, utility charges, and
insurance, or any benefit that may exist in one location but not the other.
Example Sensitivity Analysis -
Given Data
Project Cost 500000
Life 8 years
Depreciation Straight line method
Unit sales 100000
Selling price 5 per unit
Variable cost 2 per unit
Operating fixed cost 80000
Tax rate 25%
Discount rate 10%
Cash flow Determination
Revenue (100000*5) 500000
Less: Variable cost (100000*2) (200000)
Operating Fixed cost (80000)
EBIT 220000
Less : Depreciation(500000/8) (62500)
EBT 157500
Less: Tax @25%(157500*.25) (39375)
EAT 118125
Add: Depreciation 62500
Net cash inflow per year 180625
NPV=A [1-(1+I) ^-n/I]-ICO
NPV=180625[1-(1+.10)^-8/.10]-500000
= (180625*5.3349)-500000
= 463616
Now we see what happen in NPV if there is an error of 10%
S. Factors Estimates Revision Revised cash flow Revised
N NPV
.
1 Life 8 years 7 [{(100000+*5)-(100000*2)-80000- 405474
(500000/7)}*(1-.25)]+(500000/7)]
=182360
2 Unit sales 100000 100000( [{(90000+*5)-(90000*2)-80000- 343580
1-.10) (500000/8)}*(1-.25)]+(500000/8)]
= 90000 =158125
3 Selling 5 5(1-.10) [{(100000+*4.5)-(100000*2)-80000- 263558
price = 4.5 (500000/8)}*(1-.25)]+(500000/8)
=143125
4 Variable 2 2(1+.10) [{(100000+*5)-(100000*2.2)-80000- 383593
costs = 2.2 (500000/8)}*(1-.25)]+(500000/8)]
=165625
5 Operating 80000 80000(1 [{(100000+*5)-(100000*2)-88000- 431607
FC +.10) (500000/8)}*(1-.25)]+(500000/8)]
= 88000 =174625
6 Tax rate 25% 25%(1+. [{(100000+*5)-(100000*2)-80000- 438409
10) (500000/8)}*(1-.28)]+(500000/8)]
= 28% =175900
Calculation of revised NPV
NPV=A [1-(1+I) ^-n/I]-ICO
NPV = 182360[1-(1+.10)^-7/.10]-500000
= 405474.
From the above analysis, we can see that if there is an error of 10% the factors of selling price,
unit sales, variable cost have a great impact on NPV compared to other factor’s i.e. Life operating
fixed cost tax rate.
