Capital rationing is a process through which a limited capital budget is allocated between different projects in a way that maximizes the shareholder's wealth.
Capital rationing is a method used to select a project mix in a situation when the total funds available for investment are less than total net initial investment needed by all the projects under consideration. It involves calculation of profitability indices for all projects and selecting projects that lead to highest combined net present value.
Black Gold Exploration is an oil and gas exploration company operating in northwestern Qamadan. It has secured four exploration licenses from the government for Block C,L and Y. Black Gold Exploration has total budget of $8 billion. Block C, L and Y are expected to generate total value (present value of cash flows) of $5 billion, $6 billion and $4 billion respectively while the respective initial investment required for each is $3 billion, $4 billion and $3 billion. Find the optimal product mix.
In order to maximize shareholders' wealth, the company has to accept projects that maximize total value added. For this, it needs to rank the projects in the descending order of their profitability indices and accept projects with higher profitability indices till there are no enough funds available for next project.
Block C's profitability index = $5 billion/$3 million = 1.67
Block L's profitability index = $6 billion/$4 billion = 1.5
Block Y's profitability index = $4 billion/$3 billion = 1.33
Since the total budget is $8 billion, BGE can invest only in Block C and L. It will have to surrender Block Y. Although Block Y has positive net present value, the company does not have any funds to invest in the block.
Written by Obaidullah Jan, ACA, CFA