Question

19. The major advantage provided by the profitability index is it:
A. provides a better measure of the effects of a project on shareholder wealth than NPV.
B. eliminates the need to estimate the firm's cost of capital.
C. is useful as an aid in ranking projects from best to worst.
D. reduces the forecast error of cash flow estimates.
E. is easier to calculate than NPV.

20. A firm has determined its cost of capital is 12.5%. It is considering three projects. Project F requires an initial investment of $25,000 with NPV of cash inflows equal to $35,000. Project G requires an initial investment of $50,000 with NPV of cash inflows equal to $60,000. Project H requires an initial investment of $75,000 with NPV of cash inflows equal to $80,000. Which of the following statements is (are) correct? (x) All three projects are acceptable because the NPV of each project is greater than zero.
(y) The profitability index for all three projects is greater than one but the profitability index for Project H is the largest because it requires the largest investment.
(z) Since the profitability index for Project F exceeds the profitability index for Project G, the firm should pursue Project F before it purses Project G.
A. (x), (y) and (z)
B. (x) and (y) only
C. (x) and (z) only
D. (y) and (z) only
E. (z) only

Answer 1

19). Option C - Since profitability index is a ratio (relative measure), it can be used to rank projects from best to worst.

20). Profitability index = NPV of cash inflows/initial investment.

NPV = NPV of cash inflows - initial investment.

Project	Profitability index	NPV
F	1.40	10,000
G	1.20	10,000
H	1.07	5,000

Statement x is correct as all three projects have positive NPV and so, are acceptable.

Statement z is correct as profit from project F is more than from project G, project F should be pursued first.

(Option C is correct.)