Corporate

Finance

Ashraful Alam
Capital Investment
Appraisal: Inflation,
Taxation and capital
rationing
Part 2

Ashraful Alam
Learning Objective

• Apply profitability index to arrive at best decision if

investment capital is rationed
Capital Rationing

Capital rationing
• occurs when funds are not available to finance all wealth
enhancing projects.

Types:
• Soft capital rationing
• Hard capital rationing
Technique for dealing
with Capital Rationing

Profitability index (PI)

• is the ratio of the cumulated present values of future cash
flows to the present cash flow at time 0.
OR
PI = PV/Initial investment
Capital Rationing –
Example 2.6

Suppose
Project that your company had Year
Outlay the following
1 opportunities:
Year 2
A (10,000) 30,000 5,000
B (5,000) 5,000 20,000
C (5,000) 5,000 15,000

Only £10,000 is available to undertake investments

appropriate discount rate is 10%. Which project should be
selected?
Capital Rationing –
Solution 2.6

Project Outlay PV PI Ranking

A (10,000) 31,405 3.1 3rd
B (5,000) 21,074 4.2 1st
C (5,000) 16,942 3.38 2nd

Profitability index = present value/investment

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