Question

University Hospital has four capital projects under consideration with the following investments and projected cash flows. What is their optimal capital budget allocation if their corporate cost of capital is 12%?

	Year	0	1	2	3	4	5
Project
A		(600,000)	50,000	90,000	150,000	200,000	250,000
B		(400,000)	80,000	100,000	100,000	100,000	100,000
C		(700,000)	100,000	220,000	250,000	250,000	250,000
D		(350,000)	90,000	120,000	150,000	150,000	150,000

Answer 1

Profitability Index should be used for evaluating the projects instead of NPV, if the projects to be compared are having different Initial Capital Outlay.

In this case, the cash outflow from each project is different from other, So, Profitability Index Should be used for catital Budgeting decisions.

Profitability Index is a capital budgeting tool used to rank projects based on their profitability. It is calculated by dividing present value of all cash inflows by the initial investment. Projects with higher profitability index are better.

(Refer Screen shots below)

	Year	PVF @ 12%	Cashflows - Project A	PV		Cashflows - Project B	PV		Cashflows - Project C	PV		Cashflows - Project D	PV
a	0	1	$                     (600,000)	$           (600,000)		$                      (400,000)	$      (400,000)		$                      (700,000)	$       (700,000)		$                     (350,000)	$     (350,000)
			PV of Cash Outflows	$           (600,000)		PV of Cash Outflows	$      (400,000)		PV of Cash Outflows	$       (700,000)		PV of Cash Outflows	$     (350,000)
b	1	0.8929	$                          50,000	$                44,643		$                           80,000	$          71,429		$                        100,000	$           89,286		$                          90,000	$         80,357
	2	0.7972	$                          90,000	$                71,747		$                        100,000	$          79,719		$                        220,000	$         175,383		$                       120,000	$         95,663
	3	0.7118	$                       150,000	$              106,767		$                        100,000	$          71,178		$                        250,000	$         177,945		$                       150,000	$       106,767
	4	0.6355	$                       200,000	$              127,104		$                        100,000	$          63,552		$                        250,000	$         158,880		$                       150,000	$         95,328
	5	0.5674	$                       250,000	$              141,857		$                        100,000	$          56,743		$                        250,000	$         141,857		$                       150,000	$         85,114
			PV of Cash Inflows	$        492,117.67		PV of Cash Inflows	$ 342,620.48		PV of Cash Inflows	$   743,349.66		PV of Cash Inflows	$ 463,229.19
c	Profitability Index		= b/a	$                     0.82		= b/a	$               0.86		= b/a	$                1.06		= b/a	$              1.32

Here, Profitability Index for Projects A and Project B are less than 1, which means Present Value of cash inflows are less than Present value of cash outflows, i.e., NPV is Negative. So, it is not advisable to accept A and B.

Among Project C and Project D, Project D is having higher Profitability Index (i.e., amount of $ 1.32 is generated for every $1 investment in Project D), hence Project D should be given first priority.

However Project C can also be accepted.

If Projects are mutually exclusive, Accept Project D. (Capital Rationing = 350,000)

If Projects are independent, Accept both Projects (C & D). (Capital Rationing = $ 350,000 + $ 700,000 = $ 1,050,000)