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CA Final · Advanced Financial Management · Advanced Capital Budgeting Decisions

Under single-period capital rationing with indivisible projects, why can ranking by profitability index alone give a suboptimal selection?

Ranking by profitability index can be suboptimal for indivisible projects because it may leave part of the budget unused, while a different combination using funds more fully could give a higher total NPV. The goal is maximum total NPV, not highest index.

  1. ABecause the profitability index ignores the time value of money
  2. BBecause the profitability index is always negative for large projects
  3. CBecause the budget may be left partly unused after selecting highest-ranked projects, so another combination may give a higher total NPVCorrect
  4. DBecause the profitability index rewards projects with the lowest NPV

Explanation

With indivisible projects, taking the top-ranked ones can leave unused funds that cannot fit the next project, while a different combination using the budget more fully may yield a higher total NPV. The index does consider discounted cash flows, so the first option is wrong.

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