BUSF_A01.qxd

Capital rationing

A business is unable or unprepared to invest more than £500,000 in the current year, but has

the following projects available to it:

Project Initial investment NPV

££

A 100,000 15,000

B 150,000 29,000

C 140,000 31,000

D 210,000 22,000

E 180,000 36,000

Which of these projects should the business invest in?

Example 5.6

The NPV per £of investment and thus the ranking of the projects is as follows:

Project NPV/£ of investment Ranking

A0.154

B0.193

C0.221

D0.105

E0.202

The business should therefore take on the projects in the order shown until the capital is

exhausted. This would mean taking on projects as follows:

Project £

C 140,000

E 180,000

B 150,000

A (30/100 thereof ) 30,000

500,000

Solution

The solution to Example 5.6 assumes that it is possible to take on 30/100 of Project

A and that the cash flows of that project will simply be reduced to 30 per cent of their

original figures, giving an NPV of 30 per cent of the original NPV. In reality this

assumption may well be without foundation. If this were the case, the decision maker

would have to look at the various combinations of the projects that have total initial

investment outlays of £500,000 and then choose the combination with the highest total

NPV. Some trial and error is likely to be involved with finding this combination.

Obviously, use of the NPV per £ of investment approach (usually known as the

profitability index) will cause NPV to be maximised for the level of investment finance

involved.

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