Question

You are asked to evaluate the following two projects for the Norton corporation. Use a discount rate of 10 percent. Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods.

Project X (Videotapes of the Weather Report) ($14,000 Investment		Project Y (Slow-Motion Replays of Commercials) ($34,000 Investment)
Year	Cash Flow	Year	Cash Flow
1	$7,000	1	$17,000
2	$5,000	2	$10,000
3	$6,000	3	$11,000
4	$5,600	4	$13,000

a. Calculate the profitability index for project X. (Do not round intermediate calculations and round your answer to 2 decimal places.)

Profitability Index -

b. Calculate the profitability index for project Y. (Do not round intermediate calculations and round your answer to 2 decimal places.)

Profitability Index -

c. Which project would you select based on the profitability index?

Project X

Project Y

Answer 1

Profitability index (PI) is a financial tool which tells us whether an investment should be accepted or rejected.

If it is greater than 1, it indicates the present value of future cash inflows from the investment is more than the initial investment thereby indicating that it will earn profits.

The formula for calculating PI is Present Value of Cash Flows/ Initial Investment

Project X

Initial investment = $14000

Years Cash Flows PVF Present Value

1. 7000 0.909 6363

2. 5000 0.826 4130

3. 6000 0.751 4506

4. 5600 0.683   3824.8

18823.8

PI = 18823.8/14000

= 1.34

Project Y

Initial investment = $ 34000

Years Cash Flows PVF Present Value

1. 17000 0.909 15453

2. 10000 0.826 8260

3. 11000 0.751 8261

4. 13000 0.683 8879

40000

PI = 40000/34000

= 1.18

Since both the projects have PI greater than 1, but the desirability factor is more in Project X

Hence Project X should be choosen.