Corporate Finance

Free Cash Flow Valuation 
 195

Profitability Index = NPV/Initial investment

Profitability index is sometimes specified as Present Value of Cash inflows divided by present value of

cash outflows.

Exhibit 9.7 Implementing the capital-rationing decision—who makes allocation and selection

Allocation and selection decisions Frequency Percentage

Capital is allocated to each division, which then prioritize 35 54 percent

investment opportunities within the allocation

Each division submits all positive NPV proposals and project selection 26 40.6 percent

is done at the central management level

A combination of the above two 4 6.0 percent

To t a l 65 100.0 percent

To calculate a Profitability Index:

1. Estimate the investment required for each project.


2. Identify the total amount of funds available for investment.


3. Calculate PI for all projects and rank them from highest to lowest.


4. Start from the project that has the highest PI and move downwards. Accept those projects that can be
   funded by available capital.

A company has a capital constraint of Rs 1 crore. It has the following projects:

Project Investment NPV

1 1.0 1.0

2 2.0 2.2

3 3.0 3.3

4 3.0 2.4

5 1.0 0.7

6 4.0 4.8

Exhibit 9.8 Why internal capital rationing?

Statement SD D NS A SA Score

Capital rationing is used to discourage

biased cash flow forecasts 4 7 8 34 12 0.66

Rationing is more severe when managers have a job

mobility 8 25 23 8 1 – 0.48

When senior managers cannot trust project forecasts
and when the project’s downside risk is large 1 7 4 40 13 0.88
Firms are more likely to reject a +ve NPV project
when it is non routine/unique in nature 2 16 5 33 9 0.48
Firms impose rationing and avoid low NPV projects
in order to preserve borrowing capacity to finance
potentially high NPV projects in the near future 1 8 6 40 10 0.78
Note:SD = Strongly disagree, D = Disagree, NS = Not sure, A = Agree, SA = Strongly agree.
Their points are –2, –1, 0, 1, and 2 respectively.