Question

Suppose the following two independent investment opportunities are available to Greene, Inc. The appropriate discount rate is 12 percent.

Year	Project Alpha				Project Beta
0	−$	4,300			−$	5,900
1		2,200				1,300
2		2,100				4,300
3		1,400				3,900

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

Which project(s) should the company accept based on the profitability index rule?

• Neither project

• Project Alpha

• Both projects

• Project Beta

Answer 1

Project Alpha:

Discount Rate = 12%

Present Value of Cash Inflows = $2,200/1.12 + $2,100/1.12^2 + $1,400/1.12^3
Present Value of Cash Inflows = $4,634.8852

Profitability Index = Present Value of Cash Inflows / Initial Investment
Profitability Index = $4,634.8852 / $4,300
Profitability Index = 1.08

Project Beta:

Discount Rate = 12%

Present Value of Cash Inflows = $1,300/1.12 + $4,300/1.12^2 + $3,900/1.12^3
Present Value of Cash Inflows = $7,364.5909

Profitability Index = Present Value of Cash Inflows / Initial Investment
Profitability Index = $7,364.5909 / $5,900
Profitability Index = 1.25

Based on profitability index, company should accept Project Beta as its profitability index is higher.