Question

Preference Ranking

Information on four investment proposals is given below:

Investment Proposal

A                    B                     C                     D

Investment required            $(85,000)       $(200,000)     $(90,000)       $(170,000)

Present value of cash flows 119,000           250,000      135,000            221,000

Net present value                $34,000            $50,000      $45,000            $51,000

Life of the project                  5 years             7 years       6 years             6 years

Required:

Compute the project profitability index for each investment proposal.

Rank the proposals in terms of preference.

Answer 1

Profitability index = present value of future cash flows / initial investment = (initial investment + net present value) /initial investment

Investment proposal A

Profitability index = (85000+34000)/85000 = 1.40

Investment proposal B

Profitability index = (200000+50000)/200000 =1.25

Investment proposal C

Profitability index = (90000+45000)/90000 = 1.50

Investment proposal D

Profitability index = (170000+51000)/170000 = 1.30

Ranking :

Rank 1 - investment proposal C (because it has highest Pi)

Rank 2 - investment proposal A

Rank 3 - investment proposal D

Rank 4 - investment proposal B (because it has lowest PI)