Question

You have to choose between two options using   PI (profitability index) as your project evaluation tool. The company use a 15% discount rate

• The project “A” needs $25,000 for initial investment and will produce in 3 years $18,000 per year.
• The project “B” needs $50,000 for initial investment and will produce in 3 years $35,000 per year

Answer 1

The profitability index is computed as shown below:

= Present value of future cash flows / Initial Investment

The profitability index of project A is computed as follows:

The present value of future cash flows is computed as follows:

= $ 18,000 / 1.15 + $ 18,000 / 1.15² + $ 18,000 / 1.15³

= $ 41,098.05211

So, the profitability index will be as follows:

= $ 41,098.05211 / $ 25,000

= 1.64 Approximately

The profitability index of project B is computed as follows:

The present value of future cash flows is computed as follows:

= $ 35,000 / 1.15 + $ 35,000 / 1.15² + $ 35,000 / 1.15³

= $ 79,912.8791

So, the profitability index of project B will be as follows:

= $ 79,912.8791 / $ 50,000

= 1.60 Approximately

Since the profitability index of project A is greater than the profitability index of project B, hence firm shall choose project A.

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