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CS Executive · Corporate Accounting and Financial Management · Capital Budgeting

Under capital rationing, why is ranking projects only by NPV potentially misleading when projects are indivisible?

Ranking by individual NPV can mislead because, with a fixed budget and indivisible projects, one large high-NPV project may consume the funds, whereas a combination of smaller projects could give a higher total NPV. The objective is maximising combined NPV within the budget.

  1. ANPV cannot be computed when funds are limited
  2. BChoosing the largest-NPV project may use up funds that a combination of smaller projects could use for a higher total NPVCorrect
  3. CNPV always equals IRR under rationing
  4. DRationing makes the cost of capital zero

Explanation

With a fixed budget and indivisible projects, the goal is to maximise total NPV of the combination chosen. A single large project may exhaust the budget, while several smaller ones together may yield more total NPV, so the profitability index and combinations are examined.

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