Corporate Finance

196
Corporate Finance

The profitability index and ranking are shown here:

Project PI Ranking

1 1.0 3

2 1.1 2

3 1.1 2

4 0.8 4

5 0.7 5

6 1.2 1

Projects 6, 3, 2, and 1 can be chosen to exhaust the capital budget of Rs 1 crore. The cumulative NPV is

Rs 1.13 crore.

Exhibit 9.9 Flexibility of the investment ceiling

Ceiling Percent

Circumstances under which a firm would lower the original ceiling
Never lower the ceiling 6 9
When it currently has low NPV projects 22 34
When it has better prospects in future 14 22
When actual cash flows are lower than predicted 18 27
Other reasons 5 8
To t a l 65 100

Circumstances under which initial allocation is increased
Never raise the ceiling 6 9
When it has to give up high NPV projects 28 43
When it doesn’t impair future ability to issue debt 14 22
When actual cash flows are better than predicted 8 12
Other reasons 9 14

To t a l 65 100

Limitations of Profitability Index

If the objective is to choose that investment whose PI is greater than 1, calculation of PI is unnecessary as
NPV is positive! Second, PI is a function of NPV and investment. It penalizes those projects that have higher
cash outlays even if the incremental investment is worthwhile. This ‘scale problem’ was demonstrated earlier.
Third, the implicit assumption in calculating PI is that the capital rationing constraint applies to current
period and not future periods.
The cumulative investment need not exactly equal capital constraint. A portion may be left unutilized. The
unutilized portion may be used to accept a fractional project (that is, staggering the investment). Sometimes
another combination of projects may yield a higher NPV.

Projects with Unequal Lives

One of the limitations of the NPV rule is that it is biased towards longer-term projects. So it is likely that a
shorter term project may be discarded without considering the fact that the proceeds of the project can be
reinvested at termination. Consider the example here: