The method provides correct rankings of mutually exclusive projects, when one is Not subject to capital rationing.
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A. B. C. D.A
The correct answer is A. Net present value.
Net present value (NPV) is a capital budgeting method that calculates the present value of cash inflows minus the present value of cash outflows, discounted at the required rate of return. The result is a net amount, which represents the expected increase or decrease in the value of the firm if the project is undertaken.
In capital budgeting, projects compete for limited resources. Capital rationing occurs when a company has limited capital and cannot fund all projects that meet its investment criteria. Under capital rationing, it is important to rank projects in order of their potential contribution to the firm's value.
When capital is not rationed, the ranking of projects is based on their net present value. A project with a higher net present value is preferred over a project with a lower net present value. NPV takes into account the time value of money and the expected cash flows of the project over its entire life.
Internal rate of return (IRR) is another capital budgeting method that calculates the rate at which the present value of cash inflows equals the present value of cash outflows. Projects with an IRR higher than the required rate of return are accepted. However, IRR does not take into account the size of the investment or the scale of the project, and it may lead to incorrect rankings of mutually exclusive projects.
Payback period measures the time required for the cash inflows of a project to equal the initial investment. Projects with shorter payback periods are preferred. However, payback period ignores the time value of money and does not consider the cash flows beyond the payback period, which may result in incorrect rankings of projects.
Profitability index (PI) is the ratio of the present value of cash inflows to the initial investment. Projects with a higher PI are preferred. However, PI does not consider the scale of the project and may lead to incorrect rankings of mutually exclusive projects.
In conclusion, when capital is not rationed, net present value is the correct method to rank mutually exclusive projects as it considers the time value of money and the expected cash flows of the project over its entire life.