Question

Suppose your firm is considering two mutually exclusive, required projects with the cash flows shown below. The required rate of return on projects of both of their risk class is 10 percent, and that the maximum allowable payback and discounted payback statistic for the projects are 2 and 3 years, respectively.

Time:	0	1	2	3
Project A Cash Flow	-27,000	17,000	37,000	8,000
Project B Cash Flow	-37,000	17,000	27,000	57,000

Use the PI decision rule to evaluate these projects; accept the project with the higher PI value.

rev: 05_15_2019_QC_CS-167992

Multiple Choice

• reject A, accept B

• accept neither A nor B

• accept A, reject B

• accept both A and B

Answer 1

The profitability index of project A is computed as shown below:

= Present value of future cash flows / Initial investment

Present value is computed as follows:

= Future value / (1 + r)ⁿ

= 17,000 / 1.10 + 37,000 / 1.10² + 8,000 / 1.10³

= 52,043.57626

So, the profitability index will be computed as follows:

= 52,043.57626 / 27,000

= 1.9275 Approximately

The profitability index of project B is computed as shown below:

= Present value of future cash flows / Initial investment

Present value is computed as follows:

= Future value / (1 + r)ⁿ

= 17,000 / 1.10 + 27,000 / 1.10² + 57,000 / 1.10³

= 80,593.53869

So, the profitability index will be computed as follows:

= 80,593.53869 / 37,000

= 2.1782 Approximately

Since the PI of Project B is greater than the PI of Project A, Project B shall be accepted.

So, the correct answer is reject A, accept B.

Feel free to ask in case of any query relating to this question