BFI 333: PROJECT APPRAISAL

PROJECT APPRAISAL UNDER

CAPITAL RATIONING

Presenter: Dr. Samuel Kariuki

 Capital Rationing
 Occurs any time there is a budget constraint or ceiling on the amount of
money that can be invested during a specific period of time (For example, the
company has to depend on internally-generated funds because of borrowing
difficulties, or a division can make capital expenditures only up to a certain
ceiling).

 With capital rationing, the firm attempts to select the combination of

investments that will provide the greatest increase in the firm of the value
subject to the constraining limit.

 This achieved by employing the profitability index which ranks projects on

the basis of the return per shilling of initial investment outlay.
Types of capital rationing
1. External/hard capital rationing- As a firm goes
for more capital the use of additional capital
comes at an increased cost to the firm. The
increase in price is so great that it renders low
return projects undesirable.
2. Internal Capital rationing- It is caused by self-
imposed restrictions by the management e.g. A
decision not to incur additional debts i.e. a policy
to rely on internally generated funds.
Use of PI in Capital Rationing
 PI helps to select a portfolio of projects which yield s
highest possible NPV with the available funds.
 Steps:
1. Compute PI for all the projects
2. For mutually exclusive projects retain the one with the
highest PI greater than 1.
3. Rank the projects in the order of their PI values
4. Beginning with the project having the highest PI Value
until their accumulated total costs exhaust the
available capital
Limitations of PI
 PI procedure does not work in the following
situation;
1. Multi-period capital constraints
2. Project indivisibility
NOTE: These problems can be solved by using linear
programming approach to capital rationing.
Illustration
 Uchumi Ltd. has six projects available for investment
as follows:
Project Initial Cost (Sh. NPV at 15% Cost of
“Million”) Capital
1 60 21
2 15 9
3 20 9
4 55 15
5 30 20
6 40 -2
Required
 The firm has Sh.100 Million available for
investment. Evaluate which projects should be
undertaken to maximize shareholders wealth.
 End

Thank You