NPV Limitations Under Capital Rationing: What’s the Issue?

Imagine you are a savvy investor, always on the lookout for promising opportunities. Net Present Value, or NPV, is a powerful tool in your arsenal, like a financial compass guiding you towards the most profitable paths. It essentially tells you the present value of all the future cash flows a project is expected to generate, minus the initial investment. Think of it as a measure of the project’s net contribution to your wealth in today’s dollars. A positive NPV generally signals a good project, one that is expected to increase your wealth. The higher the NPV, the seemingly better the project.

Now, imagine you have a limited amount of money to invest, perhaps like having a set budget for home renovations. This situation is what we call capital rationing. It means you have more potentially good projects than you have funds to invest in. This is where a potential issue arises when relying solely on NPV for project evaluation.

Consider this scenario. You have two exciting project proposals on your desk. Project Alpha has an NPV of $100,000 and requires an initial investment of $500,000. Project Beta has an NPV of $80,000 but only needs an initial investment of $200,000. If you had unlimited funds, choosing Project Alpha based solely on its higher NPV would seem like the obvious choice. It promises a larger absolute increase in your wealth.

However, with capital rationing, you might not have $500,000 available. Perhaps your total budget is only $600,000. In this case, you could undertake Project Beta and still have $400,000 remaining to potentially invest in other opportunities. If you choose Project Alpha, you use up most of your budget and cannot pursue other potentially valuable, smaller projects.

The problem with relying solely on NPV in this scenario is that it focuses on maximizing the total net value, but it doesn’t explicitly consider the efficiency of capital utilization when funds are limited. NPV doesn’t tell you how much value you are generating per dollar invested. In our example, Project Alpha generates $100,000 of net value for a $500,000 investment, which is a return of 20 cents of net value per dollar invested. Project Beta, on the other hand, generates $80,000 of net value for a $200,000 investment, which is a return of 40 cents of net value per dollar invested.

When capital is rationed, maximizing the return per dollar invested becomes crucial. You want to choose the combination of projects that gives you the highest total NPV within your budget constraint. Simply selecting projects with the highest NPV might lead you to choose a few large projects, like Project Alpha, and leave potentially more profitable smaller projects, like Project Beta and others, untouched simply because you ran out of funds.

In situations of capital rationing, a metric like the Profitability Index, or PI, becomes more useful. The Profitability Index is calculated by dividing the present value of future cash flows by the initial investment. It essentially measures the value created per dollar invested. For Project Alpha, the Profitability Index would be 1.2, meaning for every dollar invested, you get back $1.20 in present value. For Project Beta, the Profitability Index would be 1.4, meaning for every dollar invested, you get back $1.40 in present value.

Using the Profitability Index, Project Beta looks more attractive because it offers a higher return per dollar of investment. Under capital rationing, prioritizing projects with a higher Profitability Index, while staying within your budget, can often lead to a greater overall wealth creation compared to simply choosing projects based solely on the highest NPV. NPV is still valuable, but in a world of limited resources, considering metrics like the Profitability Index alongside NPV provides a more nuanced and effective approach to project selection and ultimately helps you make the most of your limited capital.