#5 Suppose you calculate the Profitability Index (PI) for a project, given the p

Question

#5

Suppose you calculate the Profitability Index (PI) for a project, given the project cash flows and a required rate of return of 12%. After you calculate the PI, you discover that the actual required rate of return is 14%. The new PI you calculate using a required rate of return of 14% would be

a. lower than the PI calculated with a required rate of return of 12%.

b. higher than the PI calculated with a required rate of return of 12%.

c. the same as the PI calculated with a required rate of return of 12%.

d. uncertain because it could be either lower or higher than the PI calculated with a required rate of return of 12%.

a. lower than the PI calculated with a required rate of return of 12%.

b. higher than the PI calculated with a required rate of return of 12%.

c. the same as the PI calculated with a required rate of return of 12%.

d. uncertain because it could be either lower or higher than the PI calculated with a required rate of return of 12%.

Explanation / Answer

a. Lower than the PI calculated with a required rate of return of 12%

option a is correct.

PI = Present value of future cash flows/ initial investment

If rate of return increases, PV will decrease hence PI will decrease.

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