(Question)
The capital rationing system being utilized is fundamentally flawed since, in some instances, projects that do not increase earnings per share are selected over projects that do increase earnings per share.
Is this comment correct?
Answer: No, incorrect.
Earnings per share (EPS) is not a suitable criteria to evaluate capital budgeting projects. Under capital rationing, a firm selects the projects that increase the value of the firm by the greatest amount (i.e., have the highest NPV) subject to the capital constraints of the firm's budget. It is perfectly possible that projects that increases EPS will NOT get selected while selecting the project with the highest NPV (if its capital budget will allow it) since it adds more value.
Sunday, February 20, 2011
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