Question

Suppose your firm is considering two mutually exclusive, required projects with the cash flows shown below. The required rate of return on projects of both of their risk class is 8 percent, and that the maximum allowable payback and discounted payback statistic for the projects are 2 and 3 years, respectively.

Time:	0	1	2	3
Project A Cash Flow	-35,000	25,000	45,000	16,000
Project B Cash Flow	-45,000	25,000	35,000	65,000

Use the PI decision rule to evaluate these projects; which one(s) should it be accepted or rejected?

Answer 1

Profitability index is a ratio of the discounted cash flow to the initial cash flow of the project. It is calculated using the below formula:

Profitability Index= PV of future cash flows/Initial investment

Project A

Net present value is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0=-35,000
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the third cash flow cash flow, press the NPV button and enter the interest rate of 8%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The present value of cash flows is $39,429.71.

Profitability Index= $39,429.71/$35,000= 1.1266.

Project B

Net present value is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0=-45,000
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the third cash flow cash flow, press the NPV button and enter the interest rate of 8%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The present value of cash flows is $59,754.10.

Profitability Index= $59,754.10/$45,000= 1.3279.

Project B should be accepted since it has the higher profitability index.