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Que –
A company is experiencing capital rationing in year 0, when only $60,000 of investment finance will be
available. No capital rationing is expected in future periods, but none of the three projects under
consideration by the company can be postponed. The expected cash flows of the three projects are as
follows.
Project Year 0 Year 1 Year 2 Year 3 Year 4
$ $ $ $ $
A (50,000) (20,000) 20,000 40,000 40,000
B (28,000) (50,000) 40,000 40,000 20,000
C (30,000) (30,000) 30,000 40,000 10,000
The cost of capital is 10%. You are required to decide which projects should be undertaken in year 0, in
view of the capital rationing, given that projects are divisible.
Answer – The ratio of NPV at 10% to outlay in year 0 (the year of capital rationing) is as follows.
Outlay in
Project Year 0 PV NPV Ratio Ranking
$ $ $
A 50,000 55,700 5,700 1.114 3rd
B 28,000 31,290 3,290 1.118 2nd
C 30,000 34,380 4,380 1.146 1st
My que – I have calculated everything I am not sure about how did they get the ratios in thisThe ratio here is the PV divided by the initial outlay.
So for Project A, it is 55.700 / 50,000 = 1.114.
Although this would get full marks, it is more common to calculate the profitability ratio as the NPV divided by the initial outlay. For Project A it is 5,700 / 50,000 = 0.114.
Either approach is valid – the ranking will obviously remain the same.
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