Question

The profitability index of a proposed investment project will be:

• equal to 1.0 if the net present value is positive.

• negative if the proposed investment meets the cost of capital target.

• less than 1.0 if the net present value is negative.

• greater than 1.0 if the cost of capital exceeds the internal rate of return.

Answer 1

Profitability Index

= Present value of inflows / Initial investment

Net present value

= Present value of inflows – Present value of outflows

Now, if Net Present Value is positive, the Profitability index will be greater than 1 as the numerator of the formula of profitability index (Present value of inflows) will be greater than the denominator ( Initial investment) and so the Profitability Index will not be 1 and option a is not correct

Present value of inflows is calculated by discounting the cash flows with the cost of capital. Now, if the cost of capital requirements are met, the project will generate the required cash flows and the profitability index will be equal to 1 as the present value of inflows will be equal to present value of outflows and so the profitability index will not be negative and so option b is also not correct

If the Net Present Value is negative, the present value of inflows will be less than the initial investment and so as per the above equation of profitability index, the Profitability Index will be less than 1. So, option c is correct

The internal rate of return is the actual rate of return generated by a project. If the cost of capital is more than the internal rate of return, the Net Present Value will be negative and so the profitability index will be less than 1 and not greater than 1 and so option d is also not correct

So, as per above discussion, option c is the correct option