Project III has the highest PI. However, that project would use only $650,000 of the total capital funding that is available. $850,000 of the funds would not be used. Therefore, this could not provide the greatest total NPV that is possible.
This combination includes Project I which has a PI of 0.5. Because that project's PI is less than 1, we know its NPV is negative. Therefore Project I is not an acceptable project, so this combination of projects cannot be an acceptable combination.
The maximum amount available for capital investment is $1,500,000. So we need to select the projects that can be initiated for that amount (or less) and that have the highest NPVs and PIs. Project I has a PI of less than 1, so we know its NPV will be negative and thus it is unacceptable. Of the three remaining projects, III and IV have the highest PIs. Their investment cost totals $1,400,000, which is within the budget. So Projects III and IV should probably be recommended. However, we should confirm that by calculating the NPVs of all three remaining projects, because using only the PIs of projects can lead us to an incorrect conclusion. The Profitability Index is the Present Value of Future Cash Inflows divided by the Investment Cost. Therefore, we can calculate the Present Value of Future Cash Inflows for each of the three acceptable projects by multiplying the Investment Cost by the Profitability Index. Once we have the Present Value of Future Cash Inflows, we can calculate the NPV of each project by subtracting its Investment Cost from its Present Value of Future Cash Inflows. We will not include Project I in this analysis, since we already know it is not acceptable. Profitability PV of Future Project Investment Index Cash Inflows NPV II $450,000 1.4 $ 630,000 $180,000 III 650,000 1.8 1,170,000 520,000 IV 750,000 1.6 1,200,000 450,000 Projects III and IV have the highest NPVs. Their total NPV is $970,000, which is higher than any other possible combination of projects. Since their total investment is also within the budget limit, those are the projects to recommend.
This combination is unacceptable for two reasons. (1) Its total investment is $1,700,000, which is greater than Carbide's budget ceiling of $1,500,000. (2) It includes Project I, and Project I has a PI of 0.5. Because that project's PI is less than 1, we know its NPV is negative. Therefore Project I is not an acceptable project, so this combination of projects cannot be an acceptable combination.
|
Carbide's budget ceiling for initial outlays during the present period is $1,500,000. The proposed projects are independent of each other. Which project or projects would you recommend that Carbide accept?