Capital Project Ranking Decisions

Question 1

In what circumstance might the use of the payback period approach be useful in ranking capital projects?

Answer 1

When liquidity issues are a major concern in selecting from a set of projects.

Question 2

Describe the concept of capital rationing.

Answer 2

Limiting the number of economically feasible projects that are undertaken and selecting those that will be undertaken.

Question 3

In ranking economically feasible projects, what is the primary shortcoming of the net-present-value approach?

Answer 3

It fails to take into account differences in the initial cost of economically feasible projects. Each project is evaluated independently of each other project, therefore differences in initial cost among projects is not considered.

Question 4

Give three reasons for capital rationing.

Answer 4

1. Insufficient funds to undertake all economically feasible projects
2. Insufficient management capacity to take on all economically feasible projects
3. Perceived instability in the market/economy

Question 5

What is the preferred method of ranking economically feasible projects?

Answer 5

The Profitability Index, which takes into account both the Net Present Value and the initial cost of each project