Types of Capital Rationing – Hard and Soft

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.

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
amount of funds available for investments in projects. However, these restrictions can be
modified in the future; hence, the term ‘soft’ is used for it.

Reasons for Capital Rationing

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.

 A depressed stock market and share prices when share prices are very low in the market and
a firm will be discouraged from issuing new shares because it will issue a huge number of
shares, in order to raise required funds and this will issue a huge number of shares and this
will dilute the ownership and control the future of E.P.S

 Perceived riskiness of the firm by the lenders may assume that the firm is of a high risk
(financial) especially if the is heavily geared .if the firm experiences high fluctuations in
operating profit there are chances of not attracting capital.

 High floatation costs-this is where the cost of raising funds is very high
  Budget deficit –A huge government budget deficit requires a huge domestic borrowing and
this will exact an upward pressure on domestic interest rates causing the debt to go up for
the companies and this will discourage the firms from borrowing.

However, these restrictions can be modified in the future; hence, the term ‘soft’ is used for it.

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.ie When the
company doesn’t want to issue extra ordinary shares so as to prevent dilution of earnings and
control of ownership

 An increase in Opportunity Cost of Capital: Too much leverage in the capital structure makes
the company a riskier investment. This leads to 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.

 There might be a capital limit set by the budget committee on amounts of funds a project
undertaken by a company.

 The firms may not be willing to raise capital or borrow debt because of fixed obligation of
repaying capital and interest and also gearing up the company and also interfere with the debt
equity ratio.

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.