16
PROJECT SELECTION UNDER
CAPITAL ATIONING R
7
CONTENTS
Capital Rationing 141
Single-period capital rationing 142
Single Period Capital Rationing with Divisible Projects 142
Single Period Capital Rationing with Mutually Exclusive Divisible
Projects 143
Single Period Capital Rationing with Indivisible Projects 143
Multi-Period Capital Rationing 144
CAPITAL RATIONING
Capital rationing occurs when a firm cannot undertake all profitable projects due
to limited available funds. In an ideal market scenario, a firm could raise any
amount of capital needed at the market interest rate. However, in reality, market
imperfections mean that raising capital often comes at increasing interest rates,
reaching a point where borrowing is no longer possible. This situation is known
as external capital rationing. Additionally, firms may internally decide to limit
investments to what can be financed from retained earnings or within a specific
budget, leading to internal capital rationing. These constraints can be
categorized into 'hard' and 'soft' views of capital rationing:
Soft Capital Rationing: This occurs when a company has a limited amount of
funds available for investment but can still borrow more funds at a cost (e.g.,
interest on loans). In this scenario, the company has some flexibility to raise
additional capital, albeit at a higher cost.
Hard Capital Rationing: This occurs when a company has a strict limit on the
amount of funds available for investment and cannot borrow more funds at any
cost. In this scenario, the company has no flexibility to raise additional capital,
and must make do with the limited funds available.
Due to these limitations, it is essential that selected projects not only cover their
cost of capital but also maximize returns on the limited available funds. This
necessitates a ranking system for project selection.
Under capital rationing, the usual decision rule to accept all projects with a
positive NPV is not sufficient. The objective changes to maximizing returns from
a batch of projects within the capital limitations. This transforms the decision-
making process into a ranking problem. Different approaches are required based
on whether the projects are divisible or indivisible, and whether the capital
rationing is single-period or multi-period.
Divisible Projects: These are projects that can be scaled up or down depending
on the amount of capital available. For example, a marketing campaign can be
reduced in scope or expanded depending on the budget. Divisible projects can be
partially funded and still generate returns proportional to the amount invested.
Indivisible Projects: These are projects that require a specific minimum
investment to be viable and cannot be scaled down. For example, building a new
factory or launching a new product often requires a fixed minimum investment
to be feasible. Indivisible projects require a lump sum investment and cannot be
partially funded.
142 Olaniyi Evans | University Mathematics
SINGLE-PERIOD CAPITAL RATIONING
Single-period capital rationing occurs when a company has limited funds for
projects with positive NPV in a single period. To maximize returns, projects must
be ranked using the Profitability Index (PI) instead of NPV, as NPV favors larger
projects.
S i n g l e P e r i o d C a p i t a l R a t i o n i n g w i t h D i v i si bl e P r o j e c t s
This situation is the simplest. Projects are ranked by their PI, which is the NPV
per unit of outlay. Projects, or fractions of them, are selected until the available
capital is exhausted.
EXAMPLE 16.1
China Company has a cost of capital of 15% and a limit of $2500 available for
investment. The investment required and the NPV at 15% are shown below:
Project Outlay ($) NPV @ 15% ($)
I 500 200
II 1,000 700
III 850 950
IV 1,300 800
V 370 90
VI 1,100 -120
What projects should be initiated?
S O L U T I O N tips
Compute PI:
𝐍𝐏𝐕
𝐏𝐫𝐨𝐟𝐢𝐭𝐚𝐛𝐢𝐥𝐢𝐭𝐲 𝐈𝐧𝐝𝐞𝐱 =
𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐎𝐮𝐭𝐥𝐚𝐲
Rank Projects
Compute PI: Based on PI:
Project Outlay NPV @ 15% PI Project PI
($) ($)
I 500 200 0.400 III 1.118
II 1,000 700 0.700 II 0.700
III 850 950 1.118 IV 0.615
IV 1,300 800 0.615 I 0.400
V 400 100 0.243 V 0.243
VI 1,100 -120 -0.109 VI -0.109
NOTE: Project VI has a negative NPV, it is inadvisable to invest in it, as it may
not generate the desired returns or may even lead to financial losses.
Optimal investment plan:
Project Fraction Investment NPV
undertaken
III 1 850 950
II 1 1,000 700
IV 0.5 650 400
2,500 2,050
China Company should initiate Projects III, II, and IV, yielding the maximum
total NPV of $2,050 within the $2,500 budget.
NOTE: This solution method applies the management accounting principle of
maximizing return per unit of the limiting factor (NPV per $ of capital) to
optimize
Chapter 16| Project Selection Under Capital Rationing 143
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