Question

a. Discuss the nature and causes of the problem of capital rationing in the context of project appraisal, and explain how this problem can be overcome in reaching the optimal investment decision for a company support your answer by examples . 300 word count please no more please

Answer 1

In project appraisal, the project shall be accepted when the NPV of the project is positive with the objective of maximization of wealth of share holder. However there may be situation due to capital rationing a firm may have select some projects among various projects all having positive NPV's, the two methods for evaluation are

I ) if the projects are independent and divisable in nature : in such situation NPV rule should be modified and accordingly project should be ranked on the basis of NPV.

Ii ) if the projects are not divisable : in such situation projects shall be ranked on the basis of absolute NPV and should be mixed up to the point available resources are exhausted.

Example :

company is limited to capital spending of 120000$

Cost of capital = 15%

Project Investment NPV @15%. NPV per 1$ Ranking

$(000). $(000). Invssted

A. (50). 15.4. 0.31. 5

B. ( 40 ). 18.7. 0.47. 2

C. ( 25 ). 10.1. 0.4. 3

D. ( 30 ). 11.2. 0.37. 4

E. ( 35 ) 19.3 0.55. 1

Buidling up a project based on rankings

If the project is divisable

Project. Investment (000$) NpV@15%

E. 35. 19.3

B. 40. 18.7

C. 25. 10.1

D. 20 ( max ). 7.5

Total. 120. 55.6

If the project is not divisable :

Projects. Investments NPV@15%

E+B+C. 100. 48.1

E+B+D. 105. 49.2  

In this case E+B+D would be prefered as NPV is high.