Question

Newago, Inc. is strapped for cash for investment projects and must decide which of four projects it will fund. Below are the projects and information about them:

Life Of:

Net The Internal

Investment Present Project Rate Of

Project Required Value In Yrs. Return

1. 80,000 210,000 6 13%

2. 750,000 340,000 10 17%

3. 845,000 333,000 7 12%

4. 695,000 202,000 5 18%

A. Compute the project profitability index for each project.

B. Rank the four projects in order of preference in terms of:

Internal rate Of Return

Project Profitability Index

Net Value

C. Which of the three rankings above do you prefer?

What are the strengths and weaknesses of each method?  

Answer 1

Project	Investment required	Net present value	Life of the project	IRR
1	80000	210000	6	13%
2	750000	340000	10	17%
3	845000	333000	7	12%
4	695000	202000	5	18%
Project	Net present value	Investment required	Profitability Index of Projects =1+(NPV/Investment required)
1	210000	80000	3.63
2	340000	750000	1.45
3	333000	845000	1.39
4	202000	695000	1.29
Ranking on the Basis of IRR
Rank	Projects	IRR
1	4	18%
2	2	17%
3	1	13%
4	3	12%
Ranking on the Basis of NPV
Rank	Projects	NPV
1	3	845000
2	2	750000
3	4	695000
4	9	80000
Ranking on the Basis of Profitability Index
Rank	Projects	PI
1	1	3.63
2	2	1.45
3	3	1.39
4	4	1.29
I would prefer ranking of Profitability Index because according to the PI ranking, projects are ranked on the basis of the benefits provided over the value of Investment required

Major Weakness of the IRR method is its assumptions like it consider that intermediate cash flows are reinvested at a rate equal to IRR which in actual not possible, drawback of NPV method is that It consider the value of benefits in terms of dollars and ignores the value of initial investment. while PI method consider the both cash inflow and outflow to calculate the ratio between the two and it is the best method to rank the project.