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This term is used when there are several possible projects and the funds available aren't sufficient to undertake them all.
Projects are ranked based on several criteria in order to decide which projects to direct the available funds towards first.
The most agreed upon method of ranking is the Profitability Index Method:
Present Value of Future Cash Flows / Initial Investment
There prioritize projects when the size of the money was not enough to complete a full batch one excludes its proceeds projects that cost less or greater, according to standards established in the proportion of projects in profitability and return on these projects is used in the completion of projects excluded temporarily
Ranking of Mutually exclusive projects is needed when there is capital rationing situation and funds are limited. Method used to rank positive NPV mutually exclusive projects is profitability index (PI). This method helps ranking most beneficial projects according to availability of funds.
The net present value (NPV) and internal rate of return (IRR) methods yield the same accept or reject rule in case of independent conventional investments. However, in real business situations there are alternative ways of achieving an objective and, thus, accepting one alternative will mean excluding the other. Investment projects are said to be mutually exclusive when only one investment could be accepted and others would have to be excluded. For example, in order to distribute its products a company may decide either to establish its own sales organization or engage outside distributors. The more profitable out of the two alternatives shall be selected. This type of exclusiveness may be referred to as technical exclusiveness. On the other hand, two independent projects may also be mutually exclusive if a financial constraint is imposed. If limited funds are available to accept either project X or project Y, this would be an example of financial exclusiveness or capital rationing. In the case of independent projects ranking is not important since all profitable projects will be accepted. Ranking of projects, however, becomes crucial in the case of mutually exclusive projects.
Ranking of investment projects also known as Capital Rationing is required when there are various investment proposals with positive net-present-value, but funds are limited so we can not undertake all profitable project. In this case we normally use Profitability Index i.e. NPV per dollar invested for each investment project. In this case projects with highest PI ration are undertaken to maximise total NPV of all projects to be undertaken within the limited or constraining resources to finance them.
Agree with Mr. Vinod Jetly
