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Further aspects of investment appraisal

Capital Rationing

Capital rationing occurs when insufficient funds are available to
understake all NPV-positive projects.

The objective of all capital rationing exercises is the maximisation of the
total NPV of the chosen projects’ cash flows at the cost of capital. Thus,
it becomes necessary to rank projects to enable the optimum
combination to be undertaken.

NPV
–––––––––––––––
Profitability Index =
Initial investment

Alternatively the index may be shown as:

Present Value of net cash inflows
Profitability Index =
–––––––––––––––––––––––––––––
Initial investment

The optimal investment plan is determined by:

Step 1: Calculate a PI for each project

Step 2: Ranking the projects according to their PI

Step 3: allocate funds according to the projects’ rankings until they
are used up

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