Case

When capital is rationed, the optimal investment schedule is the one that maximises the return per dollar invested. The capital

rationing problem is therefore concerned with limiting factor analysis, but the approach adopted is slightly different depending

on whether the investment projects being evaluated are divisible or indivisible.

With divisible projects, the assumption is made that a proportion rather than the whole investment can be undertaken, with

the net present value (NPV) being proportional to the amount of capital invested. If 70% of a project is undertaken, for

example, the resulting NPV is assumed to be 70% of the NPV of investing in the whole project.

For each divisible project, a profitability index can be calculated, defined either as the net present value of the project divided

by its initial investment, or as the present value of the future cash flows of the project divided by its initial investment. The

profitability index represents the return per dollar invested and can be used to rank the investment projects. The limited

investment funds can then be invested in the projects in the order of their profitability indexes, with the final investment

selection being a proportionate one if there is insufficient finance for the whole project. This represents the optimum

investment schedule when capital is rationed and projects are divisible.

With indivisible projects, ranking by profitability index will not necessarily indicate the optimum investment schedule, since

it will not be possible to invest in part of a project. In this situation, the NPV of possible combinations of projects must be

calculated. The most likely combinations are often indicated by the profitability index ranking. The combination of projects

with the highest aggregate NPV will then be the optimum investment schedule.