Soft Capital Rationing and Hard Capital Rationing
Capital rationing is the process of placing some restrictions on capital expenditure due to its scarcity.
Capital expenditure is the process of investing to expand the business operation. It is very important for all companies. In order to maximize shareholders’ wealth, management needs to find the opportunity to invest more capital to get more returns. It includes purchasing more fixed assets to increase production capacity, investing in new products, and even purchasing new subsidiaries.
However, the funds are limited, the company cannot invest in all available projects or opportunities. They have to select the best project which has low risk and high return. There are many factors to take into consideration when selecting an investment project.
In some circumstances, the management decides to restrict new investment due to the lack of funds. They may restrict low-return investment and only invest in the best profitable project.
It is the planning which restricts the company from making a new investment. If there are many available projects or investments, capital rationing will help them to filter only the most profitable projects. The company can implement this strategy by setting a higher required return on investments (ROI) for new investments.
Investors aim to maximize their return with their available resources. Capital rationing aims to achieve this objective. It only allows to invest in the most profitable investment and left behind lower profitable investments.
Type of Capital Rationing
There are two types of capital rationing which are hard and soft capital rationing.
Soft Capital Rationing
Soft capital rationing is the situation in which company decides to restrict itself from making a new investment. The company actually has enough capital to invest in more projects but they decide to make the investment on a highly profitable project. There are many reasons behind the soft capital rationing.
First, the company raises too much capital in a short time, and there will be limited capital in the future. They know the capital is limited, they cannot keep raising more and more capital in the future. So managements are willing to invest only in a high-profit project and keep the remaining capital for future investment. They believe that there will be more profitable investments in the future. If they invest now, they will miss better opportunities in the future.
Second, the market condition is not good, the company is willing to keep the money rather than lose them. During the market crisis, most of the investments are uncertain, so it will be risky to invest. Management will keep the money and wait for a stable market.
Moreover, the company is keeping a good capital structure. Raising too much debt will be a problem in the future, company will not balance between debt and equity. Most companies need to follow the internal policy to maintain the gearing ratio, so it will strict for them to accept all projects.
Hard Capital Rationing
Hard Capital Rationing is the situation company is unable to make investments due to a lack of funds. It is forced by external factors that are not under company control. There are several reasons which create hard capital rationing for the company.
First, the company is not able to obtain a loan from a bank or creditor due to a low credit rating. Bank will access the company before providing loan. If they find that the company is risky, they will not provide a loan.
Second, new start-ups may be hard to find new capital due to uncertainty of future profit. Most of the new start-up is not making any profit in the first several years, so it is very hard to convince investors to make the investment.
Moreover, company cannot obtain a loan due to the restriction from current creditors. A creditor such as a bank will put a limitation on the amount of debt that company can obtain. If the company breaks these covenants, it may face a penalty.
The company can implement capital rationing for one or more periods to ensure selecting the right investment. However, the soft capital rationing cannot be kept for too long as they will lose the opportunity cost. The sleeping capital may have some costs which will reduce the company’s profit rather than generate a return.
Capital rationing is the strategic decision that is set at the top management level. It depends on the risk appetite of the management. Some managements are able to raise more capital to invest in almost every opportunity. While the other management is only interested in a certain project which can generate returns at a certain level.