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ACCA Strategic Professional · Advanced Financial Management · Financial strategy formulation

Kestrel plc has a capital budget of $500,000 this year only and faces a set of independent, divisible projects with positive NPVs. Which approach should the senior financial adviser use to select projects under this single-period (hard or soft) capital rationing?

Rank divisible projects by profitability index, meaning NPV per dollar of scarce capital, and accept them in order until the budget is exhausted. This maximises total NPV under a single-period constraint, whereas ranking by absolute NPV, IRR or payback ignores how efficiently each project uses the limited capital.

  1. ARank projects by profitability index (NPV per $ of capital invested) and accept in order until the capital is used upCorrect
  2. BRank projects by absolute NPV and accept the largest first
  3. CRank projects by IRR and accept those above the cost of capital
  4. DRank projects by shortest payback period

Explanation

With one binding constraint and divisible projects, NPV is maximised by ranking on NPV per unit of the scarce resource, i.e. the profitability index. Ranking by absolute NPV ignores the amount of capital used, so it can leave capital under-utilised in value terms.

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