Suppose the following two independent investment opportunities are available to

Question

Suppose the following two independent investment opportunities are available to Greene, Inc. The appropriate discount rate is 9 percent.

Compute the profitability index for each of the two projects. (Do not round intermediate calculations and round your answers to 3 decimal places, e.g., 32.161.)

Which project(s) should the company accept based on the profitability index rule?

Project Alpha

Both projects

Project Beta

Neither project

Year Project Alpha Project Beta 0 $ 5,700 $ 7,300 1 2,900 1,650 2 2,800 5,700 3 1,750 4,600

Explanation / Answer

Profitability Index = (NPV + Initial investment) / Initial investment

NPV is calculated by discounting the cashflows

PV = C/(1+r)^n

C - Cashflow

r - Discount rate

n - years to the cashflow

Project Alpha:

NPV = -5700 + 2900/(1+0.09)^1 + 2800/(1+0.09)^2 + 1750/(1+0.09)^3 = 668.58

PI = (668.58+5700)/5700 = 1.12

Project Beta:

NPV = -7300 + 1650/(1+0.09)^1 + 5700/(1+0.09)^2 + 4600/(1+0.09)^3 = 2563.38

PI = (2563.38 + 7300)/7300 = 1.35

- Choose project Beta as PI is higher than project Alpha

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