Suppose your firm is considering two mutually exclusive, required projects with
ID: 2804414 • 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 9 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 -26,000 16,000 36,000 7,000 Project B Cash Flow -36,000 16,000 26,000 56,000 Use the PI decision rule to evaluate these projects; which one(s) should be accepted or rejected? reject A, accept B accept both A and B accept A, reject B accept neither A nor B
Explanation / Answer
Profitability Index = Present Value of Cash Inflows / Present Value of Cash Outflows
Project A :
= [ $ 16,000 *1 /( 1.09) ^ 1 + $ 36,000 *1 /( 1.09) ^ 2 + $ 7,000*1 /( 1.09) ^ 3] / $ 26,000
= [50,384.66/ $ 26,000]
= 1.94
Project B :
= [ $ 16,000 *1 /( 1.09) ^ 1 + $ 26,000 *1 /( 1.09) ^ 2 + $ 56,000*1 /( 1.09) ^ 3] / $36,000
= $79,804.85 / $ 36,000
= 2.22
Since both the Projects have a Profitability Index greater than 1, both the projects would have a positive Net Present Value.Hence, the correct answer is accept both A and B.
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