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

B1aiii. Capital rationing & INdivisible projects 4 / 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 & INdivisible projects

In this case ranking by profitability index will not necessarily indicate the optimum investment schedule, since it will not be possible to invest in part of a project.

In this situation, the NPV of possible combinations of projects must be calculated.

Unfortunately with indivisible projects there is no model to help us! We simply have to look at all the possible combinations by trial and error work out which would be the most profitable. (Highest NPV)

Surplus funds may be left over, but since the highest-NPV combination has been selected, the amount of surplus funds is irrelevant to the selection of the optimal investment schedule

Illustration

A company has 100,000 to invest and has identified the following 5 projects. They are NOT DIVISIBLE.

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

Solution

  • A+C is the best mix

Project Investment required NPV
A & C 90 44
A & D 100 38
B 100 35