ACCA Strategic Professional · Advanced Financial Management · Financial strategy formulation
In a linear programming formulation of single-period capital rationing, the shadow price of the capital constraint is $0.35. What does this indicate?
A shadow price of $0.35 means each additional dollar of capital would raise total NPV by about $0.35, within the range over which the solution remains valid. It shows the maximum premium worth paying to relax the constraint, not a cost of capital or IRR.
- AEach extra $1 of capital available would increase total NPV by $0.35, within the relevant rangeCorrect
- BThe firm's cost of capital is 35%
- CEach project returns 35% IRR
- DTotal NPV falls by $0.35 for each extra $1 of capital
Explanation
The shadow price is the marginal increase in the objective (NPV) from relaxing a binding constraint by one unit, valid within a range. It is useful for judging whether raising extra funds is worthwhile.
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