AFMP4
Syllabus B. Advanced Investment Appraisal B1. Discounted cash flow techniques

B1aiii. Capital rationing & divisible projects 3 / 14

Syllabus B1aiii)

Evaluate the potential value added to an organisation arising from a specified capital investment project or portfolio using the net present value (NPV) model.

Project modelling should include explicit treatment and discussion of:

iii) Single period capital rationing.

Capital rationing & Divisible projects

Here, divisible investment projects can be ranked in order of desirability using the profitability index

Steps for the exam with divisible projects

  1. It's assumed that part rather than the whole investment can be undertaken

    If 70% of a project is performed, for example, its NPV is assumed to be 70% of the whole project NPV.

  2. Then its profitability index is calculated

  3. The profitability index is then used to rank the investment projects.

Illustration

A Company has 100,000 to invest and has identified the following 5 projects. They are DIVISIBLE.

Project Investment NPV
A 40 20
B 100 35
C 50 24
D 60 18
E 50 10

Solution

Project Working Profitability Index Ranking
A 20/40 0.5 1
B 35/100 0.35 3
C 24/50 0.48 2
D 18/60 0.3 4
E who cares!   5

Plan

Funds Project NPV
100,000    
(40,000) A 20,000
(50,000) C 24,000
(10,000) 10% of B 3,500