Capital Rationing and the profitability index
If the number of efficient capital projects (that is projects with positive NPV) exceeds the funds available, the, firm faces capital rationing. In case of mutually exclusive projects of unequal size, the NPV rule may give inconsistent results. That is, a smaller project may lead to a lower NPV than an alternative larger project, but the ratio of the present value of the net cash flows to the initial cost of the project may be higher on the former than on the latter project.
In such case, when the firm cannot undertake all projects with positive NPY, the firm should rank projects according to their profitability index and choose projects with highest profitability indexes rather than those with highest NPVs. The profitability index (PI) of a project is measured by
PI = Σtt=1 [Rt/(1+k)t]/C0
where Rt is the net cash flow in year t of the project, and Co is the initial cost of the project. With capital rationing, the firm should choose the projects with highest relative profitability.
It should be noted that economic viability of a project under private benefit and cost analysis is evaluated from the point of view of an individual investor. But social benefit-cost of public investment projects is analyzed from the viewpoint of society. The social benefit-cost ratio takes societal goals like economic growth, employment generation, self-reliance etc., into account, as against the sole objective of maximum possible return by a private investor. Under social benefit-cost analysis, externalities in form of benefits and costs are assessed. For instance, from the construction of a dam external benefits may accrue in form of picnic spots while external costs can be destruction of forest wealth. Valuation of social benefit-cost analysis is done by weighing benefits and costs to the society with shadow prices and then evaluated on the basis of various measures of investment worth. Individual investor performs valuation of projects on the basis of market prices.
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