Question

A company is considering two mutually exclusive projects, the company’s required return is 8 percent and they do not have any capital constraints. Based on the profitability index, what is your recommendation concerning these projects?

                       

                                    Project            A                                 Project B

                                    Year    Cash Flow                   Year    Cash Flow

                                       0       -$38,500                        0       -$42,000

                                       1         $20,000                        1         $10,000

                                       2         $24,000                        2         $40,000

		Neither project is acceptable.
		You should accept both projects since both of their PIs are greater than 1.
		You should accept project A since it has the higher PI.
		You should accept both projects since both of their PIs are positive.
		You should only accept project B since it has the largest PI and the PI exceeds 1.

Answer 1

Ans:- Profitability Index is calculated by ( Present Value of Cash Flow / Initial Investment). we will use the NPV function of excel to find the Present Value of cash flows.

Since it is a mutually exclusive project, therefore only one project can be selected for investment, and the Profitability Index of Project B (1.04) is greater than A (1.02), therefore as Per PI rule Project B should be selected.

Option (e) is the right answer i.e You should only accept project B since it has the largest PI and the PI exceeds 1.

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