4. Problems with Profitability Index. The Matterhorn Corporation is trying to ch

Question

4. Problems with Profitability Index. The Matterhorn Corporation is trying to choose between the following two mutually exclusive design projects: Year Cash Flow (I) Cash Flow (II) 0 -$65,000 -$24.000 1 24,000 8,000 2 29,000 14,500. 3 36,000 12,800 a. if the required return is 11 percent and the company applies the profitability index decision rules, which project should the firm accept? b. If the company applies the NPV decision rule, which project should it take? c. Explain why your answers in (a) and (h) are different.

Explanation / Answer

profitability index=Profitability index is a modification of the net present value method. Whereas present value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profibality index is a relative measure (i.e. it gives as the figure as a ratio).

Present Value of Future Cash Flows

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OPTION 1=1.1

OPTION 2=1.18

Based of profitability index=option 2

Present value of cash flows in option i=71481

NPV=6481

PRESENT VALUE OF CASH FLOWS IN OPTION 2=

NPV=4335

OPTION 1 IS PREFERRED BASED ON NPV RULE

Present Value of Future Cash Flows

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Initial Investment Required

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