MSG Team's other articles

9389 Framing Bias

Traditional economic theory assumes that investors are completely rational beings. Hence, they react to information in the same way if the content of the information is the same. However, behavioral finance theory seems to disagree with this assumption. According to them, investors interpret information in different ways if it is presented to them differently. This […]

8853 Debt Ceiling in Sporting World

In the previous articles, we have already seen that sporting franchises are required to raise a lot of capital at regular intervals. Hence, they are required to regularly raise debt from the marketplace. However, it is important to note that the decision regarding how much debt can be raised by a sporting franchise is not […]

9966 Interest Rates and Forex Market

The exchange rate between two currencies is determined by the interaction of several variables. Some variables have more influence on the determination of currency rates than the others. One such variable is the interest rate. In general, changes in the interest rate create huge fluctuations in the value of all currencies. In fact all major […]

11669 Types of Fixed Income Securities

When the term “fixed income securities” is mentioned, investors immediately conjure up images of bonds in their heads. However, this is a generalization on the part of the investors. In reality, fixed income securities can refer to many different types of securities. As an investor, one must be aware of the wide range of securities […]

9788 Impact of Covid on Pension Funds

The coronavirus pandemic was one of the biggest disruptive events that most people will witness in their entire lifetimes. The normal lives of people were completely disrupted by the pandemic. During that time, there was a lot of uncertainty and many people were doubtful whether life would return to normal for a long period of […]

Search with tags

  • No tags available.

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.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

What is Cost of Equity? – Meaning, Concept and Formula

MSG Team

Cross Border Credit Reporting

MSG Team

What is Corporate Finance? – Meaning and Important Concepts

MSG Team