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.

Definition of Hard and Soft Capital Rationing
There are two situations which may lead to capital rationing, namely hard and soft capital rationing. 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.

Benefits and Disadvantages of 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.
  • Lender’s Restrictions:
    Quite often, medium sized and large sized companies rely on institutional investors and banks for most of their debt requirements. There may be restrictions and debt covenants placed by these lenders which affect the company’s fund-raising strategy.
  • Industry Specific Factors: There could be a general downfall in the entire industry affecting the fund raising abilities of a company.

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.
  • 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.

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.

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.



  • />
  • />
  • />
  • />
Last updated on : January 16th, 2017
What’s your view on this? Share it in comments below.


  1. Zack
    • Sanjay Bulaki Borad Sanjay Borad

Leave a Reply

Hurdle Rate
  • Single Period Model – Discounted Cash Flow Model
    Single Period Model – Discounted Cash Flow …
  • Cost of Equity – Capital Asset Pricing Model (CAPM)
    Cost of Equity – Capital Asset Pricing …
  • Cost of Debt Capital Yield to Maturity
    Cost of Debt Capital – Yield to …
  • Net Present Value (NPV)
    Net Present Value (NPV)
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook

    Related pages

    formula for total asset turnoverdebt factoring companyadvantages and disadvantages of car leasingzero coupon bond in indiaideal liquidity ratiocash deposit ratio formulawhat is npv analysisleased equipment balance sheetlimitation of cvp analysisbullet bondsbooks on working capital managementytm in financedisadvantages of wealth maximizationwhat is total assets turnoverdeferred payment meaning in hindidifference between depreciation and amortisationlc usancedifference between finance lease and contract hireadvantages and disadvantages of takeovers and mergersmeaning of operating leveragecontribution margin at the break-even pointinvoicing discountingprefered dividends formulawith recourse factoringmotives behind mergers and acquisitionsclassification of industries based on raw materialshow to calculate inventory turnover periodoperating versus finance leasemerits and demerits of international tradeinventory turnover calculation exampledisadvantages of sale and leasebackunderstanding debit and credit in accountingdividend valuation model calculatordebit credit meaning accountingcash outflow meaningconcept of derivatives in financeunderstanding waccdays receivable ratio formulars fm calcicr ratioliquidation value formulafactored debtsexplain capital rationingshareholder versus stakeholderdividend discount methodlimitation of standard costingfinancial statements definition accountingwhat is meant by irrfinished goods turnover ratiostocks advantages and disadvantagesroce calculatordebts to total assets ratiodifferential costingsolve for irrmodigliani miller propositionrevaluation surplus ifrssales maximisation tutor2uasset turnover ratio formula exampledifference between loan and lenddefine total asset turnoverdefinition of intangible assets in accountingwhat are the different types of dividend policiesopportunity cost npvdebtor turnover ratio formulaactivity based budgeting disadvantagesdisadvantages of retained profitslimitations of zero based budgetingnon competitive benchmarkingadvantages of leasing equipmentformat of marginal costingrevenue meaning in hindidiscounting of letter of creditdirect and indirect relationshipsperformance based budgeting advantages and disadvantages