Question

Suppose the following two independent investment opportunities are available to Relax, Inc. The appropriate discount rate is 8 percent.

Year, Project Alpha, Project Beta

0 ?$3,500 ?$5,100

1 1,800 1,100

2 1,700 3,500

3 1,200 3,500

a. Compute the profitability index for each of the two projects. (Do not round intermediate calculations and round your answers to 3 decimal places, e.g., 32.161.) Profitability Index

Project Alpha

Project Beta

b. Which project should the company accept based on the profitability index rule?

Project Beta

Project Alpha

Answer 1

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

At 8%:

Alpha:

Present value of inflows=1800/1.08+1700/1.08^2+1200/1.08^3

=$4076.74

PI=Present value of inflows/Present value of outflows

=(4076.74/3500)=1.165(Approx)

Beta:

Present value of inflows=1100/1.08+3500/1.08^2+3500/1.08^3

=$6797.62

PI= =$6797.62/$5100

=1.333(Approx).

Hence Beta Project must be chosen having higher PI.

[However since two projects are independent;both must be accepted].