Capital rationing is a business strategy that a company uses when it places limits or restrictions on the amount of funds available for investment in new projects. All companies try to maximize returns on their investments and small businesses face additional hurdles finding money to invest in projects. Capital rationing forces the company to make careful choices when selecting investments. There are two types of capital rationing.
Hard capital rationing occurs when the investment limitations come from external forces. Investors may not be willing to gamble or previous investments may not have performed well. The company may have leveraged too much debt, or may be badly managed. Economic and market conditions may also cause investors and lenders to be tight with money and lend only at high interest rates.
Soft capital rationing occurs when the company places investment limits or restrictions on itself. A company can do this by allocating less money for investments or by increasing its cost of capital, the rate of return it requires for new investments. A small business may do this when its current investments are underperforming or the cost of borrowing becomes too high. Since it is internally imposed, this strategy can be revised if conditions change.
Suppose you’re the founder and CEO of a small business that has been investing in several projects to support growth. You’d like to invest in a couple more projects, but the rate of return on your current projects is falling far below your 15 percent cost of capital and economic conditions have caused interest rates to spike to nearly 10 percent. Your finance officer submits a budget that only allows for one investment project per year and has also increased your cost of capital to 20 percent. Your finance officer’s actions are an example of soft capital rationing, since those measures can be adjusted as opportunities arise. The actions by lenders and investors are hard capital rationing, since they are externally imposed conditions that restrict your company’s investment options.
In the real world, the choice between two investments may not be as clear cut. Decision makers generally turn to comparing the net present value (NPV) of the potential return on the options to decide which opportunity to pursue. The NPV of an investment is simply the return to be realized in the future stated in today’s dollars.