Juan is considering two independent projects. Project A costs $74,600 and cash f

Question

Juan is considering two independent projects. Project A costs $74,600 and cash flows of $18,700, $46,300, and $12,200 for Years 1 to 3, respectively. Project B costs $70,000 and has cash flows of $10,600, $15,800, and $67,900 for Years 1 to 3, respectively. Juan assigns a discount rate of 10 percent to Project A and 12 percent to Project B. Which project or projects, if either, should he accept based on the profitability index rule? Answer options: 1. accept both projects 2. accept Project A and reject Project B. 3. accept either A or B, but not both 4. reject both projects 5. accept Project B and reject Project A

Explanation / Answer

based on the profitability index rule, the Answer is :

5. accept Project B and reject Project A

=> Present value of future cash flow:

the profitability index (Project A) = Present value of future cash flow / Initial Investment

= 64404.30 / 74600 = 0.8633

the profitability index (Project B) = Present value of future cash flow / Initial Investment

= 70403.20 / 70000 = 1.00576

As per rule of the profitability index , Accept a project if the profitability index is greater than 1.

So, accept Project B and reject Project A.

year Project A- cash flow discount rate 10% Present value - Project A Project B- cash flow discount rate 10% Present value - Project B 1 $18700 0.909 16998.30 10600 0.893 9465.80 2 46300 0.826 38243.80 15800 0.797 12592.60 3 12200 0.751 9162.20 67900 0.712 48344.80 total 64404.30 total 70403.20

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