1.Types of Capital Rationing
Capital rationing: a situation in which there is not enough finance (capital) available to undertake all available positive NPV projects. Therefore, capital has to be rationed.
Hard capital rationing: the capital markets impose limits on the amount of finance available (e.g. due to high perceived risk of the company).
Soft capital rationing: the company sets internal limits on finance availability (e.g. to encourage divisions to compete for funds).
Single-period capital rationing: capital is in short supply in only one period.
Multi-period capital rationing: capital is rationed in two or more periods.
2.Single-period Capital Rationing
If projects are divisible (i.e. any portion of a project may be undertaken) the correct method is to calculate a profitability index for each project and then to rank them according to this measure.
Profitability index = Net Present Value/ Capital Invested
If projects are non-divisible there is no need to calculate the index above—the optimal investment plan can only be found using trial and error (i.e. trying different combinations of projects until the maximum possible NPV is found).
Mutually exclusive projects—where two or more particular projects cannot be undertaken at the same time (e.g. because they use the same land). In this case, use the following method:
Divide projects into groups; with one of the mutually exclusive projects in each group.
Calculate the highest NPV available from each group (assume projects are divisible unless told otherwise).
Choose the group with the highest NPV.
3.Multi-period Capital Rationing
If investment funds are expected to be restricted in more than one period, then neither the profitability index nor trialand-error approaches can be used, as they do not take into account the restriction on finance in future periods.
If projects are divisible, then a linear programming model must be formulated and solved. If there are only two projects, the solution can be found graphically. Three or more variables require a computer solution.