Question

  

1. NPV (Net Present Value) versus PI (Profitability Index)

Consider the following two mutually exclusive projects available to Global Investments, Inc.:

Projects	C0	C1	C2	PI	NPV
A	-$1000	$1000	$500	1.32	$322
B	-500	500	400	1.57	285

The appropriate discount rate for the projects is 10%. Global Investments chose to undertake project A. At a luncheon for shareholders, the manager of a pension fund that owns a substantial amount of the firm’s stock asks you why the firm chose project A instead of project B when project B has a higher PI.

How would you, the CFO, justify your firm’s action? Are there any circumstances under which Global Investments should choose project B

Answer 1

When there is no capital rationing (i.e. there is no shortage of capital), the project with higher NPV must be chosen since it will add more to the shareholders funds than the project with lower NPV. In the given situation, Project A has higher NPV as compared to Project B. Hence the decision of the company is justified when it chooses Project A.

When there is capital rationing (i.e. there is a shortage of capital) , the project with higher PI should be selected since it will provide more returns in terms of per Dollar invested. Hence when there is shortage of capital, Global Investments should choose project B since the PI of project B is higher as compared to project A.