1. NPV (Net Present Value) versus PI (Profitability Index) Consider the followin
ID: 1170622 • Letter: 1
Question
1. NPV (Net Present Value) versus PI (Profitability Index)Consider the following two mutually exclusive projects available to Global Investments, Inc.: Projects C0 C1 C2 PI NPV A -$1000 $1000 $500 1.32 $322 B -500 500 400 1.57 285
The appropriate discount rate for the projects is 10%. Global Investments chose to undertake project A. At a luncheon for shareholders, the manager of a pension fund that owns a substantial amount of the firm’s stock asks you why the firm chose project A instead of project B when project B has a higher PI.
How would you, the CFO, justify your firm’s action? Are there any circumstances under which Global Investments should choose project B 1. NPV (Net Present Value) versus PI (Profitability Index)
Consider the following two mutually exclusive projects available to Global Investments, Inc.: Projects C0 C1 C2 PI NPV A -$1000 $1000 $500 1.32 $322 B -500 500 400 1.57 285
The appropriate discount rate for the projects is 10%. Global Investments chose to undertake project A. At a luncheon for shareholders, the manager of a pension fund that owns a substantial amount of the firm’s stock asks you why the firm chose project A instead of project B when project B has a higher PI.
How would you, the CFO, justify your firm’s action? Are there any circumstances under which Global Investments should choose project B 1. NPV (Net Present Value) versus PI (Profitability Index)
Consider the following two mutually exclusive projects available to Global Investments, Inc.: Projects C0 C1 C2 PI NPV A -$1000 $1000 $500 1.32 $322 B -500 500 400 1.57 285 Projects C0 C1 C2 PI NPV A -$1000 $1000 $500 1.32 $322 B -500 500 400 1.57 285
The appropriate discount rate for the projects is 10%. Global Investments chose to undertake project A. At a luncheon for shareholders, the manager of a pension fund that owns a substantial amount of the firm’s stock asks you why the firm chose project A instead of project B when project B has a higher PI.
How would you, the CFO, justify your firm’s action? Are there any circumstances under which Global Investments should choose project B Projects C0 C1 C2 PI NPV A -$1000 $1000 $500 1.32 $322 B -500 500 400 1.57 285
Explanation / Answer
When there is no capital rationing (i.e. there is no shortage of capital), the project with higher NPV must be chosen since it will add more to the shareholders funds than the project with lower NPV. In the given situation, Project A has higher NPV as compared to Project B. Hence the decision of the company is justified when it chooses Project A.
When there is capital rationing (i.e. there is a shortage of capital) , the project with higher PI should be selected since it will provide more returns in terms of per Dollar invested. Hence when there is shortage of capital, Global Investments should choose project B since the PI of project B is higher as compared to project A.
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