Capital State University is evaluating the two investment proposals given below:

Question

Capital State University is evaluating the two investment proposals given below:
Investment Proposal
                                                    A                                  B
Investment required                 $(200,000)                 $(100,000)
Present value of cash inflows         250,000                   130,000
Net present value                       $50,000                      $30,000
Life of the project                         7years                       5 years

Ignore the impact of income taxes in your calculation.
Based on project profitability index for each investment proposal, which investment proposal should be undertaken and what is its project profitability index?

Explanation / Answer

Profitability Index (PI) is used to identify the relationship between the costs and benefits of a proposed project through the use of a ratio & is calculated as: Profitability Index (PI) = Present Value of all Future Cash Flows / Initial Cash Investment In case above, We Have PI of A = 250,000/200,000 = 1.25 PI of B = 130,000/100000 = 1.30 A profitability index of 1.0 means you have exactly achieved your desired rate of return . An index greater than 1.0 means that you've exceeded your goal. An index less than 1.0 means that you failed to achieve your goal. So here as PI of B = 1.30 is better than that of A = 1.25, so we should take Proj B for nvestment.

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