Capital Rationing

Session 12
Project Selection Under Capital Rationing
The capital rationing situation refers to the choice of investment proposals under financial
constraints in terms of a given size of capital expenditure budget.
Example 1
Cash Outflows Gross PV NPV
X 10m 17m 7m
Y 2 4 2
Z 3 4.5 1.5
W 5 11 6

All 4 projects have positive NPV, and we should have selected all.
But we don’t have 20m.

How to decide?
Objective
• The objective to select the combination of projects would be the
maximization of the total NPV.
• The project selection under capital rationing involves two stages:
• (1) identification of the acceptable projects.
• (2) selection of the combination of projects.
• The acceptability of projects can be based either on profitability index
or IRR.
Contd.
• For selection of the combination of projects we can use PV Index
(Profitability Index)

• PI = PV of CFAT / PV of Cash Outflows

where CFAT is as done in normal Capital Budgeting

Example 1 contd.
Cash Outflows Gross PV NPV PI Rank
X 10m 17m 7m 1.7 3
Y 2 4 2 2.0 2
Z 3 4.5 1.5 1.5 4
W 5 11 6 2.2 1

Arrange in descending order of Profitability Index (PI).

We use PI to pick up the projects, but the ultimate goal is to maximize shareholders’ wealth (NPV).
Example 1 contd.
• Let money available = 10m
Investment Cuml. Investment NPV Cuml. NPV
W 5m 5m 6m 6m
Y 2 7 2 8m
X (30%)* 3 10 2.1 10.1m

This is the case where the projects are DIVISIBLE.

* Assume proportional NPV accrues.

Example 1 contd.
• Is this the optimal combination?
Example 1 contd.
• Is this the optimal combination?
• Yes
• No other combination of projects gives NPV of more than 10.1
Divisible and Indivisible projects
The method of selecting investment projects under capital rationing
situation will depend upon whether the projects are indivisible or
divisible.

• In case the project is to be accepted/rejected in its entirety, it is called

an indivisible project.
• A divisible project, on the other hand, can be accepted/rejected in
part.
Example 1 contd.
• What is the projects were indivisible?

• Then W and Y only?

• Or?
Example 1 contd.
• What is the projects were indivisible?

• Then W and Y only -> NPV = 8

• W, Y and Z -> NPV = 9.5

• (Note: Only X -> NPV = 7m)

• Objective is to maximize NPV!
• If there are more options, we use permutation and combination methods
Example 2 (Divisible Project)
A company has Rs 7 crore available for investment. It has evaluated its options and has found
that only 4 investment projects given below have positive NPV. All these investments are
divisible. Advise the management which investment(s)/projects it should select.
Project Initial investment (Rs crore) NPV (Rs crore) PI
X 3.00 0.60 1.20
Y 2.00 0.50 1.25
Z 2.50 1.50 1.60
W 6.00 1.80 1.30
Example 2 contd.:
Ranking of the Projects in Descending Order of Profitability Index
Project and (rank) Investment outlay (Rs Profitability index NPV (Rs crore)
crore)
Z (1) 2.50 1.60 1.50
W (2) 6.00 1.30 1.80
Y (3) 2.00 1.25 0.50
X (4) 3.00 1.20 0.60
Accept Project Z in full and W in part (Rs 4,50,000) as it will maximise the NPV.
Example 3 (Material Q10)

(Assume indivisible projects if nothing is given)

Example 3- Solution
However, P&C gives…
Example 4 (Material Q9)
Example 4 -Solution
Soft and Hard Rationing
• Hard Rationing: When the firm cannot raise more than (say) 10m
from the capital markets

• Soft Rationing: The firm can raise more money than it wants but it
wants to limits its investment.
• Conservative/ High margin of safety
• More profitable projects will come up in future (recession/ dept wise
allocation)
Fallout of Capital Rationing
Whatever might be the reasons for capital rationing, it usually results in an
investment policy that is less than optimal.

• Capital rationing does not allow the business firm to accept all profitable
investment projects which could add to net present value and, thus, add to the
wealth of shareholders.
• Capital rationing may lead to the acceptance of several small investment
projects (promising higher return per rupee of investment) rather than a few
large investment projects. Acceptance of such a package of investment
projects is likely to have a bearing on the risk complexion of the business firm
(perhaps it may decrease).
• Finally, selection criterion of investment projects under capital rationing
(based on one-period analysis) does not reckon intermediate cash inflows
expected to be provided by an investment project.
EXAMPLE 5 (Q8 material)
Example 5 - Solution
 SOLVED
PROBLEMS
Solved Problem 1
Avon Chemical Company Ltd is presently paying an outside firm Re 1 per gallon to dispose of the waste
material resulting from its manufacturing operations. At normal operating capacity the waste is about
40,000 gallons per year.
After spending Rs 40,000 on research, the company discovered that the waste could be sold for Rs 15 per
gallon if it was processed further. Additional processing would, however, require an investment of Rs
6,00,000 in new equipment, which would have an estimated life of 5 years and no salvage value.
Depreciation would be computed by the reducing balance method @ 25 per cent. There are no other
assets in the 25 per cent block.
Except for the costs incurred in advertising Rs 20,000 per year, no change in the present selling and
administrative expenses is expected if the new product is sold. The details of additional processing costs are
as follows: variable—Rs 5 per gallon of waste put into process; fixed (excluding depreciation)—Rs 30,000
per year.
In costing the new product, general factory overheads will be allocated at the rate of Re 1 per gallon.
There will be no losses in processing, and it is assumed that all of the waste processed in a given year will
be sold in that very year. Waste that is not processed further will have to be disposed off at the present rate
of Re 1 per gallon. Estimates indicate that 30,000 gallons of the new product could be sold each year.
The management, confronted with the choice of disposing off the waste, or processing it further and selling
it, seeks your advice. Which alternative would you recommend? Assume that the firm’s cost of capital is 15
per cent and it pays, on an average, 35 per cent tax on its income.
Solution:
Cash outflows:
Cost of additional investment Rs 6,00,000
(i) Present value of cash inflows (excluding depreciation), t = 1 – 5
Particulars Amount
Increase in sales revenue (30,000 × Rs 15) Rs 4,50,000
Cost saving: reduction in disposal costs (30,000 × Re 1) 30,000
Less: Incremental costs: 4,80,000
Variable (30,000 × Rs 5) Rs 1,50,000
Fixed, manufacturing or processing 30,000
Advertising 20,000 2,00,000
Earnings before taxes 2,80,000
Less: Taxes 98,000
CFAT 1,82,000
× PVIFA (×)3.352
Total present value 6,10,064
(ii) PV of tax shield due to depreciation
Year Value Depreciation @25% Tax advantage @35% PV factor Total PV
1 6,00,000 Rs 1,50,000 Rs 52,500 0.870 Rs 45,675
2 4,50,000 1,12,500 39,375 0.756 29,767
3 3,37,500 84,375 29,531 0.658 19,431
4 2,53,125 63,281 22,148 0.572 12,669
5 189,844 0 - - Total =
1,07,542
(iii) PV of tax advantage due to short-term capital loss: [0.35 × (Rs 1,89,844) × 0.497] = Rs 33,023.
(iv) Determination of NPV
Gross present value [(i) + (ii) + (iii)] Rs 7,50,629
Less: Cost of additional investment 6,00,000
NPV 1,50,629
Note: Rs 40,000 spent on research is irrelevant cost and so is the allocated share of factory overheads.
Recommendation: Since the NPV is positive, the company is advised to purchase new equipment.
That’s all for Capital Budgeting!
(for now )