BOLTON BUSINESS SCHOOL

Module: FCMCS

Title: CAPITAL RATIONING

It is possible that the amount of funds available for investment in projects in any one
year may be limited.
If this is the case, then care has to be taken to select those projects that will produce
the highest combined NPV for the amount invested.

The combination of projects will depend upon whether each project is:

Divisible - any proportion of the project can be undertaken

and/or
Repeatable - the project can be undertaken more than once

Where funds are not restricted, ranking of projects according to absolute NPV is
satisfactory.

However if there is capital rationing then it may be found that a combination of smaller
projects may provide a collective NPV higher than one larger project, even if this
project is ranked higher according to absolute NPV.

If projects are divisible, but non-repeatable, then ranking in order of profitability index
will produce the optimum mix.

However, if the projects are not divisible, then the combination of projects providing
the highest NPV which does not exceed the capital available will be selected.

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PROFITABILITY INDEX

This tells us how much we can expect to receive in present value terms, for each pound
invested in the project.

Profitability Index:

= Present value of future cash flows

Value of initial capital investment

Example.
The following example relates to several projects, all of which are DIVISIBLE
but
NON-REPEATABLE.

See Next Sheet

PROJECT OUTLAY($) NPV( at I0%) IRR (%) PI

A 25000 3431 15.2 1.137
B 60000 6339 14.1 1.106
C 90000 4770 12.1 1.053
D 100000 2759 11.6 1.028
E 120000 10163 16.3 1.085
F 35000 1364 14.3 1.039

Total funds available for investment = $215000

1. Ranking by NPV

PROJECT NPV OUTLAY TOTAL SPEND

E 10163 120000 120000
B 6339 60000 180000
C* 1855 35000 215000
TOTAL NPV 18357

2. Ranking by IRR

PROJECT IRR NPV OUTLAY TOTAL SPEND

E 16.3 10163 120000 120000
A 15.2 3431 25000 145000
F 14.3 1364 35000 180000
B** 14.1 3698 35000 215000
TOTAL NPV 18655

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 3. Ranking by profitability index

PROJECT PI NPV OUTLAY TOTAL SPEND

A 1.137 3431 25000 25000
B 1.106 6339 60000 85000
E 1.085 10163 120000 205000
C*** 1.053 530 10000 215000
TOTAL NPV 20463

NOTE: In all three cases, only a proportion of the final project selected can be
undertaken.
The NPV in each case is apportioned on a pro-rata basis.

1. Project C* 35,000 or 7 x 4770 = 1855

90,000 18

2. Project B** 35,000 or 7 x 6339 = 3698

60,000 12

3. Project C*** 10,000 or 1 x 4770 = 530

90,000 9

Summary

Rank 1 2 3 4

NPV E B C

IRR E A F B

PI A B E C

Consider:

Non financial factors ( economic risk)

Existing cost of capital
Risk of estimates