Capital Rationing

Capital rationing is the process of selecting the best group of projects such that the highest overall net present value will result without exceeding the total budget available. An assumption with capital rationing is that the projects under consideration are mutually exclusive. There are two approaches often considered for capital rationing.

The internal rate of return approach plots the IRRs in descending order against the cumulative dollar investment. The resulting figure is often called an investment opportunity schedule. As an example, suppose a company has $300,000 committed for projects and must select from the projects identified in Table 14-20. Furthermore, assume that the cost of capital is 10%.

Figure 14-20 shows the investment opportunity schedule. Project G should not be considered because the IRR is less than the firm's cost of capital. From Figure 14-20, we should select Projects, A, B, and C, which will consume $280,000 out of a total budget of $300,000. This allows us to have the three largest IRRs.

TABLE 14-20. PROJECTS UNDER CONSIDERATION

Discounted cash

Project

Investment

IRR

flows at 10%

A

$ 50,000

20%

$116,000

B

120,000

18%

183,000

C

110,000

16%

147,000

D

130,000

15%

171,000

E

90,000

12%

103,000

F

180,000

11%

206,000

G

80,000

8%

66,000

The problem with the IRR approach is that it does not guarantee that the projects with the largest IRRs will maximize the total dollar returns. The reason for this is because not all of the funds have been consumed.

A better approach is the net present value method. In this method, the projects are again ranked according to their IRRs, but the combination of projects selected will be based upon the highest net present value. As an example, the selection of Projects A, B, and C from Table 14-20 requires an initial investment of $280,000 with resulting discounted cash flows of $446,000. The net present value of Projects A, B, and C is, therefore, $166,000. This assumes that unused portions of the original budget of $300,000 do not gain or lose money. However, if we now select Projects A, B, and D, we will invest $300,000 with a net present value of $170,000 ($470,000 less $300,000). Selection of Projects A, B, and D will, therefore, maximize net present value.

Figure 14-20.

Investment Opportunity Schedule (IOS) for Table 14-20.

Figure 14-20.

Investment Opportunity Schedule (IOS) for Table 14-20.

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Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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