15.13 Capital rationing and use of the profitability index Flashcards
What is meant by “capital rationing”?
A strategy implemented whereby a business with insufficient funds places limitations on the amount of new investments of projects undertaken.
What are the two types of capital rationing?
1 Hard capital rationing
2 Soft capital rationing
What is hard capital rationing, and what are some examples?
When lending institutions impose an absolute limit on the amount of finance available. e.g.:
- industry wide factors limiting funds
- company-specific factors like a poor track record
What is soft capital rationing, and what are some examples?
When a company voluntarily imposes restrictions limiting funds available for investment in projects, e.g.:
- internal company policies
- limited management skills for handling multiple financing options
- focusing on existing business
When is a project considered to be “divisible”?
If any fraction of the project can be undertaken.
A profitability index can be used to calculate the present value of cash flows for a project, and is useful where only a certain number of projects can be undertaken. How is PI calculated?
PI = NPV / present value of investment or initial investment.
What is the decision rule for the profitability index method of project appraisal?
PI > 1 = accepted.
What is an indivisible project?
A project which must either be undertaken in its entirety or not at all. Profitability Index cannot be used for these projects.
