Question

A company is considering two mutually exclusive projects, the company’s required return is 8 percent and they do not have any capital constraints. Based on the profitability index, what is your recommendation concerning these projects? Project A Project B Year Cash Flow Year Cash Flow 0 -$38,500 0 -$42,000 1 $20,000 1 $10,000 2 $24,000 2 $40,000

Answer 1

Solution :-

Profitability Index = Present Value of Cash Inflows / Initial Investment

Present value of Cash Inflows

Project A = [ $20,000 / ( 1 + 0.08 ) ] + [ $24,000 / ( 1 + 0.08 )² ]

= ( $20,000 * 0.926 ) + ( $24,000 * 0.857 )

= $39,094.65

Project B = [ $10,000 / ( 1 + 0.08 ) ] + [ $40,000 / ( 1 + 0.08 )² ]

= ( $10,000 * 0.926 ) + ( $40,000 * 0.857 )

= $43,552.81

Initial Investment

Project A = $38,500

Project B = $42,000

Now Profitability Index,

Project A = $39,094.65 / $38,500 = 1.02 times

Project B = $43,552.81 / $42,000 = 1.04 times

As we know Profitability Index is higher the better

So Choose Project B

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