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CA Final · Advanced Financial Management · Advanced Capital Budgeting Decisions

A firm faces a single-period capital constraint and its projects are perfectly divisible and independent. Which ranking criterion should it use to select the combination that maximises total NPV?

Rank projects by profitability index, meaning NPV per rupee of capital invested, and accept them in that order until the budget is exhausted. This maximises total NPV when projects are divisible, because each scarce rupee is put to its most productive use.

  1. AProfitability index (NPV per rupee of outlay)Correct
  2. BInternal rate of return of each project, highest first
  3. CShortest payback period, shortest first
  4. DAbsolute NPV of each project, highest first

Explanation

With one binding constraint and divisible projects, total NPV is maximised by taking projects in descending order of NPV per rupee of outlay, which is the profitability index ranking, until the budget is used up. Ranking by absolute NPV favours large projects that use up the budget inefficiently. IRR and payback ignore the size of the NPV generated per rupee.

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