(b) Limitations of the profitability index approach in a capital rationing situation
Projects that are indivisible
The technique has little use when the projects are indivisible because it cannot be used to find the
best combination of projects that will maximise the NPV.
Risk levels
It does not take account of differing levels of risk between projects. This must be dealt with
separately, for example by adjusting the discount rates.
Strategic importance of projects
It does not take into account the relative strategic importance of the different projects and the
degree to which they fit with the company's wider strategic objectives.
Cash flow patterns
It ignores the pattern of cash flows associated with the different projects. This is because it is
essentially a single period model. However, the speed with which a project starts to generate a
positive cash flow may be important to the company's subsequent investment decisions.
Relative size of projects
As with the internal rate of return method of project appraisal, this technique ignores the relative
size of the different projects. A project that generates a large overall return, albeit over a longer
period, may be more valuable to the company than one which shows a high profitability index, but
a relatively small absolute return. |
