Suppose your firm is considering two mutually exclusive, required projects with
ID: 2749959 • Letter: S
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 12 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 -29,000 19,000 39,000 10,000 Project B Cash Flow -39,000 19,000 29,000 59,000 Use the PI decision rule to evaluate these projects; which one(s) should be accepted or rejected?
answer choices:
(a) accept neither A nor B
(b) accept A, reject B
(c) reject A, accept B
(d) accept both A and B
Explanation / Answer
Formula:- PI= Present Value of cash Inflow / Present Value of cash outflow
Project A
Calculation of Present value:-
Year Cash Inflow PV @12% Pv of Cash Inflow
1 19000 0.892 16948
2 39000 0.797 31083
3 10000 0.7117 7117
Total Cash Inflow 55148
Present value of cash outflow=29000
So PI= 55148/29000=1.90
Project B
Calculation of Present value:-
Year Cash Inflow PV @12% Pv of Cash Inflow
1 19000 0.892 16948
2 29000 0.797 23113
3 59000 0.7117 42303
Total Cash Inflow 82364
Present value of cash outflow=39000
So PI= 82364/39000=2.12
As per Profitability Index method(PI)
If PI>1 then the project should be accepted.
If PI<1 then the project should be rejected.
If PI=1 then the project is in indifferent situation to accept or reject
In this example Project A PI is 1.90 which is >1 and also within limit of maximum allowable payable period of 2 years.
so this project should be accepted.
And for Project B PI is 2.12 which is >1 and also within limit of maximum allowable payable period of 3 years.
so this project should also be accepted.
so the answer is (d) accept both A and B
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