Suppose your firm is considering two mutually exclusive, required projects with
ID: 2713246 • 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 -34,000 24,000 44,000 15,000 Project B Cash Flow -44,000 24,000 34,000 64,000 Use the PI decision rule to evaluate these projects; which one(s) should be accepted or rejected? reject A, accept B accept neither A nor B accept A, reject B accept both A and B
Explanation / Answer
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 -34,000 24,000 44,000 15,000 Project B Cash Flow -44,000 24,000 34,000 64,000 Use the PI decision rule to evaluate these projects; which one(s) should be accepted or rejected? (a) Reject A, accept B (b) Accept neither A nor B (c) Accept A, reject B (d) Accept both A and B Ans (c) Accept A, reject B 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 -34,000 24,000 44,000 15,000 Project A Cumulative Cash Flow -34,000 -10,000 34,000 49,000 Project B Cash Flow -44,000 24,000 34,000 64,000 Project B Cumulative Cash Flow -44,000 -20,000 14,000 78,000 Project A: $34,000/$15,000 = 2+2.2666 = 4.26 percent PB = 2 + 34000 = 2.266666667 4.2666667 426.66667 percent 15000 Project B: $14000/$64000 = 2+ 0.21875 = 2.218 percent 0.21875 2 2.21875 221.875 percent Profitability Index = Present Value of Future Cash Flows Initial Investment Required = 1 + Net Present Value Initial Investment Required Profitability Index = 1 + (Net Present Value / Initial Investment Required) Project A 1+(34000/15000) 3.266666667 Profitability Index = 1 + (Net Present Value / Initial Investment Required) Project B 1+(14000/64000) 1.21875 Project A is accepted and reject Project B Decision Rules Of Profitability Index(PI) A. If projects are independent Accept the project when PI is higher than 1. Reject the project when PI is less than 1. B. If projects are mutually exclusive Accept the project which has higher PI.(PI must be greater than one) Reject other project. In above calculation, project A should be selected because it has higher PI.
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