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In the previous few articles we have come across different metrics that can be used to choose amongst competing projects. These metrics help the company identify the project that will add maximum value and helps make informed decisions to maximize the wealth of the firm.
We saw how the NPV rule was better than IRR and the profitability index and how decisions based on NPV are supposedly more accurate.
However, we need to understand that there is a difference between how the NPV rule is stated in text books and how it is applied in real life worldwide.
This difference arises because when we consider capital budgeting, we are working under the fundamental assumption that the firm has access to efficient markets. This means that if the required rate of return is greater than the opportunity cost of capital, or if the project has an NPV greater than zero, the firm can always finance its projects by raising money from the markets even if it doesn’t have any. Thus for practical purposes, the money at the firms disposal is unlimited.
However, in reality this may not be the case. True, that firms can always raise money and bigger firms can raise as much funds as they want to, but many times firms themselves place restrictions on the amount of fund raising that they undertake.
These restrictions could be placed because of the following reasons:
This restriction placed on the amount of capital that the company has, nullifies the assumption inherent in capital budgeting. Thus, what happens in real life is a slightly modified version of capital budgeting. Financial analysts have a name for this. They call it “Capital Rationing”.
So capital rationing is nothing but capital budgeting with modified rules. Now instead of choosing every project that has an NPV greater than zero, the firm uses a different approach.
All projects with a positive NPV qualify for a possible investment. These projects are then ranked according to their attractiveness. The firm then invests in the top3 or top 5 projects (based on their resources). So, here a finite amount of capital is being rationed amongst projects as opposed to an infinite capital assumption.
But, how does the firm decide which projects are the most attractive? Simply ranking the projects with higher NPV will be incorrect. This is because we are not paying attention to the input we are putting in.
We are simply paying attention to the output which is obviously incorrect. What if a project with a slightly higher NPV requires double the investment as compared to another project? Is it still a good bet?
Obviously not and to solve this problem and ration capital effectively, companies have come up with a metric called the Profitability Index. The profitability index is nothing but the NPV of the project divided by the amount of its investment.
Profitability Index = NPV/Investment
So we are simply looking at the NPV amount per dollar of investment. Projects with highest NPV per dollar of investment are considered more attractive and the investment dollars are first allocated to them so that the returns of the firm are maximized.
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