Question

Anne is considering two independent projects with 2-year lives. Both projects have been assigned a discount rate of 13 percent. She has sufficient funds to finance one or both projects. Project A costs $38,500 and has cash flows of $19,400 and $28,700 for Years 1 and 2, respectively. Project B costs $41,000, and has cash flows of $25,000 and $22,000 for Years 1 and 2, respectively. Which project, or projects, if either, should you accept based on the profitability index method and what is the correct reason for that decision?

a. You should accept both projects since both of their PIs are positive.

b. You should accept Project A since it has the higher PI and you can only select one.

c. You should accept both projects since both of their PIs are greater than 1.

d. You should only accept project A since it has the largest PI and the PI exceeds one.

e. Neither project is acceptable.

Answer 1

Project A:

Cash Flows:

Year 0 = -$38,500
Year 1 = $19,400
Year 2 = $28,700

Discount Rate = 13%

Present Value of Cash Inflows = $19,400/1.13 + $28,700/1.13^2
Present Value of Cash Inflows = $39,644.45

Profitability Index = Present Value of Cash Inflows / Initial Cash Outflow
Profitability Index = $39,644.45 / $38,500
Profitability Index = 1.03

Project B:

Cash Flows:

Year 0 = -$41,000
Year 1 = $25,000
Year 2 = $22,000

Discount Rate = 13%

Present Value of Cash Inflows = $25,000/1.13 + $22,000/1.13^2
Present Value of Cash Inflows = $39,353.12

Profitability Index = Present Value of Cash Inflows / Initial Cash Outflow
Profitability Index = $39,353.12 / $41,000
Profitability Index = 0.96

You should only accept project A since it has the largest PI and the PI exceeds one.