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ACCA Strategic Professional · Advanced Financial Management · Discounted cash flow techniques

Under capital rationing in a single period where projects are divisible and not repeatable, which approach correctly ranks projects to maximise total NPV?

Projects should be ranked by profitability index, meaning NPV per dollar of capital invested, and funded in that order with the final project taken fractionally. This maximises total NPV when capital is the single limiting factor and projects are divisible.

  1. ARank by IRR and accept down to the budget limit
  2. BRank by profitability index (NPV per $ of capital invested) and accept in order, taking a fraction of the last projectCorrect
  3. CRank by absolute NPV and accept down to the budget limit
  4. DRank by payback period and accept the quickest

Explanation

With divisible projects and a single-period constraint, the scarce resource is capital, so projects are ranked by NPV per unit of capital (profitability index) and funded in order, with the last project part-funded. Absolute NPV ranking ignores size of outlay, and IRR ignores scale and can mislead.

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