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
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.
Then its profitability index is calculated
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 |