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Hi,
When a question says ” A company is experiencing capital rationing in year 0 and only 60,000 investment is available.” 3 projects available all with 4 year life.Project :
A needs 50,000 Year 0
B needs 28,000 Year 0
C needs 30,000 Year 0Data is taken from BPP book, capital rationing chapter.
But all the projects also need further investment in year 1 as well and there is no data given for rationing in year 1. so we take all the outflows and inflows from 1 year to year 4 and discount them first by cost of capital and then we take the npv and then we take the ratio from investment in year 0? I didn’t get this why didn’t we take cashflows from year 0 to arrive npv and then calculate the ratio with year 0 investment? why from year 1
I did watch your lecture, but in the example the rationing we did, had the outflow only once which was year 0 and all the following years were inflows.
Given that there is only rationing at time 0, it does not matter whether the later flows are inflows or outflows.
You calculate the NPV of each project as normal, and then divide by the time 0 amount invested to get the NPV per $, and then rank on this basis.
(Alternatively, and what it sounds as though BPP have done, you can calculate the PV of the flows from time 1 onwards and divide this by the amount invested at time 0. Obviously this gives different numbers, but the ranking will automatically always be exactly the same and this is all that matters in deciding which projects to invest in.)
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