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Capital Rationing, Profitability Index & Postponability Index

Capital rationing occurs when a company has a limited amount of capital to invest in potential projects. It can be caused by internal factors like management reluctance to issue shares, or external factors like restrictions on lending. There are two main approaches to allocating capital under rationing: using the profitability index, which prioritizes projects based on their net present value per dollar invested, or using the postponability index, which prioritizes projects based on the loss of NPV from postponing them. Both aim to maximize the NPV generated from limited capital.

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145 views

Capital Rationing, Profitability Index & Postponability Index

Capital rationing occurs when a company has a limited amount of capital to invest in potential projects. It can be caused by internal factors like management reluctance to issue shares, or external factors like restrictions on lending. There are two main approaches to allocating capital under rationing: using the profitability index, which prioritizes projects based on their net present value per dollar invested, or using the postponability index, which prioritizes projects based on the loss of NPV from postponing them. Both aim to maximize the NPV generated from limited capital.

Uploaded by

Sam Sam
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Capital rationing,

Profitability index
& Postponability
index
Capital rationing
• a situation in which a
company has a limited
amount of capital to
invest in potential
projects, such that the
different possible
investments need to be
compared with one
another in order to
allocate the capital
available most effectively
Capital rationing
• is brought about by
Soft Capital internal
Rationing

Hard • is brought about by


Capital • external factors.
Ratiniong
Soft Capital Rationing
Management may be reluctant to issue additional
share capital because of concern that this may lead
to outsiders gaining control of the business

Management may be unwilling to issue additional


share capital if it will lead to a dilution of earnings
per share.

Management may not want to raise additional


debt capital because they do not wish to be
committed to large fixed interest payments.
Hard Capital Rationing

Raising money through the stock market


may not be possible if share prices are
depressed

There may be restrictions on bank lending


due to government control

Lending institutions may consider an


organisation to be too risky to be granted
further loan facilities.
Single period capital
rationing
• Single period Capital Rationing meaning the shortage of
capital for one year only, normally this year is the initial year
• Single Period capital rationing can be analyzed in term of
divisible and non divisible project.

A project which can


be taken partially is
known a divisible A project which cannot
project be divided is known a
Non-divisible project
Assumptions
• If a company does not accept and undertake a project during
the period of capital rationing, the opportunity to undertake it
is lost.
• The project cannot be postponed until a subsequent period
when no capital rationing exists
• There is complete certainty about the outcome of each project,
so that the choice between projects is not affected by
considerations of risk
• Projects are divisible, so that it is possible to undertake, say,
half of Project X in order to earn half of the net present value
(NPV) of the whole project
Profitability index
• Profitability
  index is the ratio of the present value of the
project's future cash flows (not including the capital
investment) divided by the present value of the total capital
investment.
• This profitability index is a ratio that measures the PV of
future cash flows per $1 of investment, and so indicates which
investments make the best use of the limited resources
available
Illustration Single period capital
Rationing with divisible Projects
• Suppose that Hard Times Co is considering four projects, W, X, Y
and Z. Relevant details are as follows

• Without capital rationing all four projects would be viable


investments. Suppose, however, that only $60,000 was available for
capital investment. Let us look at the resulting NPV if we select
projects in the order of ranking per NPV
Illustration Single period capital
Rationing with divisible Projects

• Projects are divisible. By spending the balancing $20,000 on project


Y, two thirds of the full investment would be made to earn two thirds
of the NPV.
• Suppose, on the other hand, that we adopt the profitability index
approach. The selection of projects will be as follows
Postponability Index
• We
  have so far assumed that projects cannot be
postponed until year 1. If this assumption is removed,
the choice of projects in year 0 would be made by
reference to the loss of NPV from postponement
• Postpoanbility Index =
• The project with higher Postpoanability index will be
taken Up
Postponability Index
• A company is experiencing capital rationing in year 0, when only
$60,000 of investment finance will be available. No capital rationing is
expected in future periods, The expected cash flows of the three
projects are as follows.

• The cost of capital is 10%. You are required to decide which projects
should be undertaken in year 0, in view of the capital rationing, given
that projects are divisible
Postponability Index
Postponability Index
Postponability Index
Postponability Index
• The loss in NPV by deferring investment would be greatest for
Project C, and least for Project A. It is therefore more profitable to
postpone A, rather than B or C, as follows
Problems with the Profitability
Index method
• The approach can only be used if projects are divisible. If the projects
are not divisible a decision has to be made by examining the absolute
NPVs of all possible combinations of complete projects that can be
undertaken within the constraints of the capital available
• The selection criterion is fairly simplistic, taking no account of the
possible strategic value of individual investments in the context of the
overall objectives of the organisation
• The Profitability Index ignores the absolute size of individual projects.
A project with a high index might be very small and therefore only
generate a small NPV.

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