Question

A HCO is considering its capital budget for the coming year, five projects are under consideration. Management uses the Profitability Index to rank projects. Given this information, which projects would you recommend the organization undertake with a 4.5 million budget?

CCC	5.50%
High risk	2.50%
Low risk	2.00%
	Project A	Project B	Project C	Project D	Project E
	Low Risk	High Risk	Average Risk	Average Risk	High Risk
Year 0	(1,750,000)	(2,250,000)	(2,000,000)	(2,000,000)	(2,500,000)
Year 1	450,000	400,000	500,000	400,000	400,000
Year 2	550,000	500,000	600,000	500,000	500,000
Year 3	650,000	1,100,000	800,000	600,000	1,000,000
Year 4	750,000	1,500,000	900,000	700,000	1,100,000

Answer 1

1]	The PIs of the 5 projects are calculated below:
	PROJECT A:
	CCC = 5.50%-2.00% = 3.5% [being of low risk]
	Year	Cash flow	PVIF at 3.5%	PV at 3.5%
	1	450000	0.96618	434783
	2	550000	0.93351	513431
	3	650000	0.90194	586263
	4	750000	0.87144	653582
	Sum of PV of cash inflows		2188058
	Initial investment			1750000
	PI = Sum of PV of cash inflows/Initial investment =	1.25
	PROJECT B:
	CCC = 5.50%+2.50% = 8.0% [being of high risk]
	Year	Cash flow	PVIF at 8.0%	PV at 8.0%
	1	400000	0.92593	370370
	2	500000	0.85734	428669
	3	1100000	0.79383	873215
	4	1500000	0.73503	1102545
	Sum of PV of cash inflows		2774800
	Initial investment			2250000
	PI = Sum of PV of cash inflows/Initial investment =	1.23
	PROJECT C:
	CCC = 5.50% [being of average risk]
	Year	Cash flow	PVIF at 5.5%	PV at 5.5%
	1	500000	0.94787	473934
	2	600000	0.89845	539071
	3	800000	0.85161	681291
	4	900000	0.80722	726495
	Sum of PV of cash inflows		2420791
	Initial investment			2000000
	PI = Sum of PV of cash inflows/Initial investment =	1.21
	PROJECT D:
	CCC = 5.50% [being of average risk]
	Year	Cash flow	PVIF at 5.5%	PV at 5.5%
	1	400000	0.94787	379147
	2	500000	0.89845	449226
	3	600000	0.85161	510968
	4	700000	0.80722	565052
	Sum of PV of cash inflows		1904393
	Initial investment			2000000
	PI = Sum of PV of cash inflows/Initial investment =	0.95
	PROJECT E:
	CCC = 5.50%+2.50% = 8.0% [being of high risk]
	Year	Cash flow	PVIF at 8.0%	PV at 8.0%
	1	400000	0.92593	370370
	2	500000	0.85734	428669
	3	1000000	0.79383	793832
	4	1100000	0.73503	808533
	Sum of PV of cash inflows		2401405
	Initial investment			2500000
	PI = Sum of PV of cash inflows/Initial investment =	0.96
2]	THE RESULTS ARE TABULATED BELOW:
	PROJECT	INITIAL INVESTMENT	PI	ACCEPT/REJECT	RANK
	A	1750000	1.25	ACCEPT	1
	B	2250000	1.23	ACCEPT	2
	C	2000000	1.21	ACCEPT	3
	D	2000000	0.95	REJECT
	E	2500000	0.96	REJECT
	Projects D & E are to be rejected, as they have PI<1, indicating that they have
	negative NPVs.
	So the allocation would be rankwise:
	A	1750000
	B	2250000
	Total investment	4000000
	Balance left	500000
	If the project C is scalable, then it can be implemented by scaling down the initial
	Investment to 500,000. The cash inflows and the NPV would get reduced proportionately.
	If C is not scalable, Projects A & B should be implemented, the uninvested amount being
	500000