Capital Project Ranking Decisions

Question 1

What is the preferred method of ranking economically feasible projects?

Answer 1

The profitability index, which takes into account both the net present value and the initial cost of each project, or the equivalent annual annuity approach.

Question 2

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

Answer 2

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

Question 3

Give three reasons for capital rationing.

Answer 3

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 4

Describe the concept of capital rationing.

Answer 4

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

Question 5

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

Answer 5

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 are not considered.