CA Intermediate · Financial Management and Strategic Management · Investment Decisions
A firm has a fixed capital budget for the current year only. All the projects it is considering can be undertaken in fractions (they are divisible), and none can be repeated. Which criterion is most appropriate for selecting the projects?
The firm should rank projects by profitability index and accept them in descending order until the budget is exhausted. Under capital rationing with divisible projects, the goal is to maximise NPV per rupee of limited funds, which the profitability index measures. Absolute NPV, payback and ARR do not achieve this.
- ARank projects by profitability index and accept in that order until the budget is usedCorrect
- BAccept the projects with the highest absolute NPV regardless of outlay
- CAccept the projects with the shortest payback period
- DAccept all projects with an accounting rate of return above the cost of capital
Explanation
With single-period capital rationing and divisible projects, the aim is to maximise NPV per rupee of scarce capital. Ranking by profitability index does this. Ranking by absolute NPV favours large projects that may use up the budget inefficiently. Payback and ARR ignore the value created per rupee of capital.
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