Project November requires an initial investment of $500,000. The present value of operating cash flows is $550,000. Project December requires an initial investment of $750,000. The present value of operating cash flows is $810,000
a. Compute the profitability index for each project.
b. If the projects are mutually exclusive, does the profitability index rank them correctly?
Answer:
a. The PI for November is 550,000/500,000 = 1.1. The PI for December is 810,000/750,000 = 1.08.
b. The PI criterion would select project November because it has the higher PI. December, however, has the higher NPV ($60,000 v. $50,000) and should be selected, so the method does not rank the projects correctly.
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