Q27E - Horngren'S Financial And Managerial Accounting

Question

Hudson Manufacturing is considering three capital investment proposals. At this time, Hudson only has funds available to pursue one of the three investments.

	Equipment A	Equipment B	Equipment C
Present value of net cash inflows	\(1,647,351	\)1,969,888	\(2,064,830
Initial investment	(1,484,100)	(1,641,573)	(1,764,812)
NPV	\)163,251	\(328,315	\)300,018

Which investment should Hudson pursue at this time? Why?

Step-by-Step Solution

Answer

The business entity must invest in equipment B because it has the highest profitability index.

Step 1: Definition of Capital Rationing

The process in which the business entity limits the amount of money that can be invested in any of the new projects carried out is known as capital rationing.

Step 2: Capital rationing method for investment decision

As all the investment proposal has positive NPV, hence each investment can be accepted. However, in order to select one investment, then in this case profitability index of investment will be used. Investment with highest profitability index should be selected. 

Profitability index of each investment:

Investment	Present value of net cash inflows	/	Initial investment	=	Profitability index
Equipment A	$1,647,351	/	$1,484,100	=	1.11
Equipment B	$1,969,888	/	$1,641,573	=	1.20
Equipment C	$2,064,830	/	$1,764,812	=	1.17

The business entity must pursue investment in equipment B.