Capital budgeting
Capital rationing
When capital is limited, rank projects by NPV per riyal invested, the profitability index, to get the most value from the budget.
Learning objectives
- Calculate a project's profitability index (PI)
- Rank projects by PI and allocate a fixed capital budget
- Explain why ranking by NPV can waste a limited budget, and when PI ranking fails
In theory a company should accept every positive-NPV project. In practice budgets are capped: head office allocates a fixed capex envelope, lenders limit borrowing, or management won't raise new equity this year. That is capital rationing.
With a binding budget, the question changes from 'does this project create value?' to 'which combination of projects creates the most value for the money we have?'. The scarce resource is capital, so rank projects by value created per riyal of capital.
PI = PV of future cash flows ÷ initial outlay (= 1 + NPV ÷ outlay)
- PI > 1
- positive NPV
- Ranking
- fund projects from the highest PI down until the budget runs out
- Divisible projects
- the marginal project can be partly funded (a share of a programme)
Included with a Formula Quest membership
The rest of this lesson is for members. Members get the full lesson, including its 3 graded exercises, and every other Finance Quest lesson.