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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

A firm faces single-period capital rationing and can invest only Rs 10 lakh this year. Projects are divisible and cannot be repeated. Which approach correctly ranks projects to maximise total NPV?

Under single-period capital rationing with divisible projects, rank projects by profitability index, which is NPV per rupee of capital, and accept in order until the funds run out, taking a fraction of the last one. This maximises total NPV from the limited capital.

  1. ARank by IRR and accept from the top until funds are exhausted
  2. BRank by the profitability index (NPV per rupee of capital invested) and accept from the top, taking a fraction of the last projectCorrect
  3. CRank by shortest payback period
  4. DRank by absolute NPV and accept from the top
  5. Accept all projects with positive NPV regardless of the limit

Explanation

With divisible projects under single-period rationing, the limiting resource is capital, so projects should be ranked by NPV per rupee invested (profitability index). IRR ranking can mislead when projects differ in scale and cash flow pattern. Absolute NPV ranking ignores how much capital each project uses.

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