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CMA Exam Part 2, Section E - Capital Rationing in Capital Budgeting - YouTube
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we've talked a lot about capital
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budgeting and how it is that we're going
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to evaluate all of the different
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projects that we have available to us we
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talked about the payback method and net
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present value internal rate of return
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and
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evaluating risk and inflation all kinds
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of different things and now we're kind
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of
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getting to the end of this and turning
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our attention now to making a decision
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we've been using these screening methods
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to collect a list of
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all of the different investments that
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would be beneficial to the organization
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and excluding all of those potential
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investments that would not be beneficial
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to the organization but what we
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probably have is this nice long list of
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beneficial opportunities that we could
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invest in
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in a perfect world we would have enough
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money to be able to invest in
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all of them unfortunately i don't think
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any of us
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live in that perfect world and so we
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have
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limited resources that are available to
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us
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to invest we cannot make all of the
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investments that would be beneficial to
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the organization
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and so what we need to do is have a way
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that we can
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determine which investment should be
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made first which investment should be
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made second third
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and so on and so that's what we're
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looking at here
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with this topic of capital rationing in
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capital budgeting we don't have enough
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capital
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to make all of these investments
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so we need to determine how we're going
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to
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allocate that capital how we're going to
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use that limited capital that we can
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with the goal of providing the highest
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total return for the company
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that's what we're trying to do we're
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trying to maximize the return
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to the company the benefit to the
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company out of
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the money that we have available for
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these different investments and
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what we've been doing so far is simply
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determining whether or not an investment
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would be beneficial to the organization
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now we need to list them and again this
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isn't going to be just
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one specific tool that we use and then
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we're done
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this is a process that we're going to go
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through but we start with what is called
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the profitability index this is going to
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get a benefit
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cost ratio that represents the ratio of
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the benefits to the cost the benefits
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are
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the present value of those net cash
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inflows
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the costs are the present value of those
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net cash outflows
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so we're going to get that ratio between
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the net present value of the inflows and
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the net present value of the outflows
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in order to determine which investment
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we should make first second third and so
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on
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and again this is a starting point so
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we'll go ahead and look at the
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calculation it's not that difficult we
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take the
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present value of the future net positive
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cash inflows
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and divide that by the net initial
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investment plus the present value of any
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future net negative cash flows
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which there may not be any there may be
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no years in the future in which there's
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a negative cash flow
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a net negative total negative cash flow
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but if there are that's treated as part
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of the denominator
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so what we're going to do and we'll see
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this in an example is we calculate the
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profitability index for
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every beneficial project that we have
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all of those
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yeses when we were doing net present
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value and internal rate of return
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but we can't simply start at the most
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the highest profitability index and work
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our way down
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because we have to remember that we have
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a limited amount of money and some of
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these projects have
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different amounts of investment so what
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we need to do
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is put together what is the combination
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of investments
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that still fit within our budget that
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will maximize
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the return and what we're looking at for
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maximizing that return is
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the highest total net present value
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what are the investments the combination
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of investments
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that we have enough money to make that
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will provide
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the highest net present value for the
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organization
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and we'll go ahead and we'll look at
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this with an example so
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chips inc has the following investment
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opportunities we have requirement
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investment outlays and the present value
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of the future estimated net cash inflows
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for each of the investments are as
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follows so we have four projects
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the present value of the investment
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three hundred thousand four hundred
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fifty six hundred fifty and seven
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hundred
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000 and then we have the present value
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of those future estimated net cash
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inflows
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starting at 350 000 going all the way up
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to 1.2 million
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for project four okay so those are the
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investments
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that we could make
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chip inc budget ceiling for initial
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outlays during the present period is one
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million five hundred thousand
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the proposed projects are independent of
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each other and so the question is which
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project or projects
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should chips accept we have 1.5
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million dollars available to us now if
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we just look at what those
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investments are we could invest in any
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one individually
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we could invest in projects one two and
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three
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we could invest in all three of those we
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have enough money to do that
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but if we invest in projects one two and
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three we can't invest in project four
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we could invest in two and three okay
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well if we invest in two and three we
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also want to invest in one i guess but
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we can put together whatever
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combination so long as it doesn't go
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over 1.5
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million dollars so what we're going to
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do in this is find that combination of
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the projects
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that are going to not be more than 1.5
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million dollars
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okay all of them is 2.15 million so we
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can't do
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all of them the first step is to
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calculate the profitability index
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and the net present value of each
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project profitability index is the
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present value of the future estimated
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net cash inflows divided by those cash
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negative cash flows and the net present
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value we know what that is
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taking that net initial investment as
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well and so
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taking that information here's what we
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get for each project we have the present
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value the future estimated cash inflows
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the present value of the investment cost
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that gives us a net present value
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and at the far right the profitability
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index
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so project three has the highest
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profitability index
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and the highest net present value
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the next highest profitability index is
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project four
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and it's also the next highest net
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present value and so the highest
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profitability indices
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praying for they also have the highest
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net present values and so
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that's where we're going to invest those
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are the first
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two investments we're going to make and
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those two investments are 1.4 million
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dollars
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so we can make those two but we can't
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make any other investments
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now we could make investment two instead
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of investment three
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if we wanted to but we have much less
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net present value if we were to choose
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to invest in
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project two instead of project three and
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so it's just it's combination and this
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one it worked out well for us
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because the profitability index and the
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net present value gave us the same kind
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of conclusion in terms of how it is
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or what it is that we should invest in
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so in the situation where we
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don't have enough money to make
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investments in all of the beneficial
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opportunities that we have
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we're going to use the profitability
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index as one of the tools to kind of
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point us in the right direction to how
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we can maximize
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our overall net present value again the
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formula the present value of the future
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net
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positive cash inflows divided by
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the net initial investment and any
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negative future net cash flows that
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there are
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so it's a tool it's a starting point but
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again overall goal
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is to maximize net present value and the
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profitability index
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is what's going to help us see where it
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is we should be looking first to make
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those investments that are going to
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maximize
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the net present value for the
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organization
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