Sunday, July 4, 2010


Use of Profitability Index in Capital Rationing

Under capital rationing, we need a method of selecting that portfolio of projects which yields highest possible net present value (NPV) within the available funds.

Let us consider a simple situation where a firm has the following investment opportunities and has a 10% cost of capital.

If the firm has no capital rationing constraint, if should undertake all three projects because they all have possible net present values (NPVs). Suppose there is a capital constraint and the firm can spend only 50000$ in year zero, what should the firm do? If the firm strictly follows the net present value (NPV) rule and starts with the highest individual net present value (NPV), it will accept the highest net present value (NPV) project L, which will exhaust the entire budget. We can, however, see that projects M and N together have higher net present value (15870 $) than project L (12940 $) and their outlays are within the budget ceiling. The firm should, therefore, undertake M and N rather than L to obtain highest possible net present value (NPV). It should be noted that the firm couldn't select projects solely on the basis of individual net present values (NPVs) when funds are limited. The firm should intend to get the largest benefit for the available funds. That is, those projects should be selected that give the highest ratio of present value to initial outlay. This ratio is the profitability index (PI). In the example, M has the highest PI followed by N and L. If the budget limit is 50000 $, we should choose M and N following the PI rule.

The capital budgeting procedure under the simple situation of capital rationing may be summarized as follows:

  • The net present value (NPV) rule should be modified while choosing among projects under capital constraint. The objective should be to maximize NPV per rupee of capital rather than to maximize NPV. Projects should be ranked by their profitability index, and top-ranked projects should be undertaken until funds are exhausted.

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