Jolina C.
Arcilla
CAPITAL RATIONING
It is a process through which a limited CAPITAL BUDGET is allocated between different projects in a way
that maximizes the shareholder’s wealth.
It is used to select a project mix in a situation when the total funds available for investment are less than
the net initial investment needed by all the projects under consideration.
It involves calculation of profitability indices for all projects and selecting projects that lead to highest
combined NET PRESENT VALUE.
The companies that employ a capital rationing strategy typically produce a relatively higher INTERNAL
RATE OF RETURN.
SCENARIO OF CAPITAL RATIONING
SCENARIO 1: - Projects are divisible and constraint is a single period one.
XYZ company is considering five independent projects, and the total fund available is 3,000,000.
PROJECTS Required Initial Investment NPV at the Appropriate cost of
Capital
A 1,000,000 20,000
B 3,000,000 35,000
C 500,000 16,000
D 2,000,000 25,000
E 1,000,000 30,000
REQUIRED: Determine the optimal combination of projects assuming that the projects are divisible.
SOLUTION: The following steps may be adopted for solving the problem under this situation:
A. Calculate the profitability index of each project.
Profitability index = NPV at the appropriate cost of capital ÷ required initial outlay.1
B. Rank the projects on the basis of the profitability index calculated in (a) above.
C. Choose the optimal combination of the projects.
A.
PROJECT (a.) Required initial NPV at the Profitability index Rank (e.)
outlay (b.) Appropriate cost (d.)
of capital (c.)
(C÷B)
A 1,000,000 20,000 0.02 3
B 3,000,000 35,000 0.0117 5
C 500,000 16,000 0.032 1
D 2,000,000 25,000 0.0125 4
E 1,000,000 30,000 0.03 2
B.
Rank Projects Required initial
1 C 1,000,000
2 E 3,000,000
3 A 500,000
4 1/4 of D 500,000
TOTAL
D= 2,000,000 * 1/4 = 500,000
C. Therefore, the Optimal Combination of Projects is C, E, A and 1/4th portion of D.
XYZ company is considering five independent projects, and the total fund available is 3,000,000.
PROJECTS Required initial NPV at the Appropriate
investment cost of capital
A 1,000,000 20,000
B 3,000,000 35,000
C 500,000 16,000
D 2,000,000 25,000
E 1,000,000 30,000
REQUIRED: Determine the optimal project mix on the basis of the assumption that the projects are
indivisible.
SOLUTION: The following steps may be adopted for solving the problem under this situation:
A. Construct a table showing the feasible combinations of the project
(whose aggregate of initial outlay does not exceed the fund available for investment)
B. Choose the combination whose aggregate NPV is maximum and consider it as the optimal project
mix.
Feasible Aggregate of NPV's
combination
A,C (20,000+16,000)= 36,000
A,D (20,000+25,000)= 45,000
A,E (20,000+30,000)= 50,000
C,D (16,000+25,000)= 41,000
C,E (16,000+30,000)= 46,000
D,E (25,000+30,000)= 55,000
A,C,E (20,000+16,000+30,000)=
66,000
B. The optimal project mix is A, C, and E because the aggregate of their NPVs is MAXIMUM.
ONE PERIOD CAPITAL RATIONING
When the limits are placed on the availability of finance for positive NPV for one year only and
capital is freely available in all the rests of periods.
The projects are divisible – it means that we can undertake 50% of project A and 50% of project b. the
basic approach will be to rank the projects in such a way that NPV can be maximized from the use of
available finances.
Ranking the projects using NPV will be incorrect because NPV basis will lead to select the “big” project,
each of which has a high individual NPV but which have a lower NPV than a large number of smaller
projects with lower individual NPV’s.
Therefore, ranking should be made in terms of profitability index. This approach would only be feasible if
the projects is divisible.
If the projects are indivisible- a decision should be made by considering the absolute NPV of all possible
projects with in the constraint of limited capital.
This method is little used when project have different cash flow patterns.
Profitability index is ignoring the absolute size of individual projects. A project with high index might be
very small and therefore only generate a small NPV
MULTI-PERIOD RATIONING
When capital is in limited availability in more than one period and selection of projects cannot be made
by ranking projects according to profitability index.
Capital constraints are imposed in more than one period to restrict he acceptance of positive NPV
projects.,
SCENARIO 3: - Projects are divisible and constraint is a multi- period one
Hera Corporation has considered seven independent projects, namely, A,B,C,D,E,F and G for
implementation. The company has a capital budget of 400 million. The minimum acceptable rate of
return is 7%
RANKING BASED ON NPV
Projects Investment NRV @ 7 %
A 100,000,000 54.73
B 100,000,000 40.47
C 200,000,000 87.01111
D 200,000,000 283.011
E 200,000,000 62.73
F 50,000,000 4.76
G 50,000,000 26.08
* the optimum set compromise of projects D and C. By implementing them with an investment of
P400,000,000 ( 200,000,000 + 200,000,000), the company would earn returns whose present value is
370.21 million. (283.007 million + 87.014 million)
RANKING BASED ON IRR
Projects Investment Interest Rate
Return
A 100,000,000 13.6
B 100,000,000 15.1
C 200,000,000 22.11
D 200,000,000 20.711
E 200,000,000 12.0
F 50,000,000 11.9
G 50,000,000 16.6
* among the seven projects, Project C has the highest IRR of 22.1% this is the first subject selected and
its commitment of funds is 200 million follow by the project D has the IRR of 20.7% and its commitment
of funds also 200 million.
RANKING BASED ON PROFITABILITY INDEX (PI)
Projects Investment Profitability index
A 100,000,000 1,547.11
B 100,000,000 1.405
C 200,000,000 1.435
D 200,000,000 2.4151
E 200,000,000 1.311
F 50,000,000 1.095
G 50,000,000 1.522111
Under profitability index ranking projects D,A and G has scored the first three ranks with a total fund
commitment of 350 million. Hence Project F is selected to complete the optimum set.