You are considering the following two mutually exclusive projects. Both projects
ID: 2781756 • Letter: Y
Question
You are considering the following two mutually exclusive projects. Both projects will be depreciated using straight-line depreciation to a zero book value over the life of the project. Neither project has any salvage value. Should you accept or reject these projects based on the profitability index?
Project A
Project B
Year
Cash Flow
Year
Cash Flow
0
-$87,000
0
-$85,000
1
$31,000
1
$15,000
2
$37,000
2
$20,000
3
$44,000
3
$90,000
Required rate of return
12%
Required rate of return
14%
Required payback period
2.5 years
Required payback period
2.5 years
Required accounting return
10%
Required accounting return
11%
accept Project A and reject Project B
reject Project A and accept Project B
You cannot make this decision based on the profitability index.
reject both Projects A and B
accept both Projects A and B
Project A
Project B
Year
Cash Flow
Year
Cash Flow
0
-$87,000
0
-$85,000
1
$31,000
1
$15,000
2
$37,000
2
$20,000
3
$44,000
3
$90,000
Required rate of return
12%
Required rate of return
14%
Required payback period
2.5 years
Required payback period
2.5 years
Required accounting return
10%
Required accounting return
11%
Explanation / Answer
Answer is C.
Project A:
Required Rate of Return = 12%
Present Value of Cash inflows = $31,000/1.12 + $37,000/1.12^2 + $44,000/1.12^3
Present Value of Cash inflows = $88,493.08
Profitability Index = Present Value of Cash inflows / Initial Investment
Profitability Index = $88,493.08 / $87,000
Profitability Index = 1.02
Project B:
Required Rate of Return = 14%
Present Value of Cash inflows = $15,000/1.14 + $20,000/1.14^2 + $90,000/1.14^3
Present Value of Cash inflows = $89,294.68
Profitability Index = Present Value of Cash inflows / Initial Investment
Profitability Index = $89,294.68 / $85,000
Profitability Index = 1.05
According to Profitability Index, Project B should be selected.
But since both projects are mutually exclusive, we will not make any decision based on profitability index.
So, we cannot make this decision based on the profitability index.
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