Answer (A) is correct . Capital rationing exists when a firm sets a limit on the amount of funds to be invested during a given period. In such situations, a firm cannot afford to undertake all profitable projects. The profitability index (or excess present value index) is a method for ranking projects to ensure that limited resources are placed with the investments that will return the highest net present value (NPV). ? The indexes for Woods’ potential projects can thus be calculated as follows: Net Investment Present Profitability Project Cost Value Index I $???500,000 $??40,000 0.080 II 900,000 120,000 0.133 III 1,200,000 180,000 0.150 IV 1,600,000 150,000 0.094
Answer (B) is incorrect because Project III is more desirable than Project IV.
Answer (C) is incorrect because While Project IV is more desirable than Project I, insufficient funding is available to engage Project IV.
Answer (D) is incorrect because Projects I and II are also desirable and sufficient funding is available.
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Which of the following project options should be recommended to Woods’ management?