In: Finance
The firm is planning to invest up to £65 million next year. The information about the available investment projects is given in the table below.
Project |
The initial investment, millions of £ |
Internal rate of return |
Net present value, millions of £ |
Profitability index |
A |
50 |
15% |
12 |
|
B |
35 |
19% |
15 |
|
C |
30 |
28% |
42 |
|
D |
25 |
26% |
1 |
|
E |
15 |
20% |
10 |
|
F |
10 |
37% |
11 |
|
G |
10 |
25% |
13 |
|
H |
1 |
18% |
0.1 |
Assuming the projects are not divisible, use the profitability index(PI) as a criterion to determine the value-maximizing combination of projects. Show the calculations of the profitability indexes in the final column of the table.
Solution.>
I have solved this question in Excel. The formula used are written along with the values. If you still have any doubt, kindly ask in the comment section.
The decision rule for the profitability index is that any project with a ratio greater than one is an acceptable project. Higher the PI, better will be the project.
The reason being, PI is basically a variation of NPV rule.
Profitability index = 1 + (NPV/Initial Cost), hence if the returns are greater than cost, the PI will always be greater than 1 and will be accepted as per capital budgeting techniques.
Since the budget is 65 million, 4 Projects C,E,F and G are selected since they have the highest PI and the cost of these projects fulfilling the budget requirements.
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