1. Capital Rationing Constraints
In a perfect financial market, a business would fund every single available project that delivers a positive NPV. In the real world, companies face Capital Rationing—caps on total spending driven by bank borrowing limits or executive boards wanting to restrict debt.
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2. Divisible vs. Indivisible Capital Projects
Divisible Projects (The Profitability Index Solution)
If projects can be scaled down or accepted partially, management must maximize total returns per dollar spent. To do this, calculate the Profitability Index (PI) to rank the options:
“Profitability Index (PI)” = “Present Value of Future Operating Cash Inflows”/”Initial Capital Investment Outlay”
Project Initial Outlay PV of Cash Flows NPV Profitability Index (PI) Ranking
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Alpha $100,000 $130,000 $30,000 1.30 3rd
Beta 50,000 75,000 25,000 1.50 1st
Gamma 80,000 112,000 32,000 1.40 2nd
Management allocates its limited budget to the highest-ranked projects in order (Beta first, then Gamma) to extract the maximum possible wealth from its available funds.
Indivisible Projects (The Combination Optimization Solution)
If a project must be accepted fully or rejected completely, simple ranking fails. Management must test every possible combination of complete projects that fits within the spending cap and choose the specific combination that yields the highest absolute Total Net Present Value.
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