Corporate Finance

Capital Rationing and Ranking Projects When the Money Runs Out

The ranking tool for the normal situation: more good projects than money. Why net present value is the wrong instrument for choosing between them, what to rank on instead, and how to spot a budget constraint that is not real.

  • Advanced
  • 13 min total
  • 14 chapters

What decision this helps you make: Which subset of your approved projects to fund this year when the pool will not cover all of them, and whether the constraint you are optimising against is a genuine limit or a self-imposed number nobody has re-examined.

What this topic is

Capital rationing is having more worthwhile projects than money to fund them. It comes in two forms: hard rationing, where outside capital is genuinely unavailable or unavailable at a price worth paying, and soft rationing, where the company has imposed a ceiling on itself. Either way the decision changes shape. You stop asking whether a project is good and start asking which combination of good projects fits.

Why it matters

Under a constraint, the standard rule breaks. Ranking by net present value systematically favours large projects and can leave a meaningful amount of value on the table, because it measures the size of the prize and ignores how much of the scarce resource the prize consumed. The correct instrument is value per unit of whatever is actually scarce, and using the wrong one costs real money in every cycle it runs.

Who should learn it

Finance leaders running an annual capital cycle, owners with one pot of cash and several credible uses for it, division heads whose projects compete against siblings, and anyone who has been told the budget is fixed and never asked why.

What you will understand

  • Why ranking by net present value is wrong under a constraint, and what replaces it
  • How to compute and apply the profitability index, including where it stops working
  • The difference between hard and soft rationing, and what each one is really telling you
  • How to identify the resource that is genuinely scarce, which is often not money

Prerequisites

Common misconception

"Fund the highest net present value projects until the money runs out." That rule maximises value only when there is no constraint. Under one, net present value measures the size of a prize without reference to how much of the scarce resource it consumed, so it reliably prefers a $10 million project creating $2 million of value over five $2 million projects creating $700,000 each, and the five together create $3.5 million from the same money. Lorie and Savage set this out in 1955 and the wrong rule is still the one most capital committees use.[1]