The profitability index is the present value of future positive cash flows divided by the initial investment plus the present value of future negative cash flows (if any). The net present value of a project is the present value its of future cash inflows minus the initial investment plus the present value of future cash outflows (if any). The present value of future cash inflows is not given. However, it can be calculated using the information that is given, assuming there are no future negative cash flows. We can calculate the present value of the future cash inflows for each project by adding together the project's NPV and the amount of the initial investment. Then the present value of the future cash inflows can be divided by the initial investment to calculate the PI for each project in order to determine which project appears to be the best investment using the profitability index. Project A: The present value of the future cash flows is $10,000,000 + $1,100,000, or $11,100,000. The profitabiity index is $11,100,000 ÷ $10,000,000 = 1.11. Project B: The present value of the future cash flows is $7,000,000 + $700,000, or $7,700,000. The profitabiity index is $7,700,000 ÷ $7,000,000 = 1.11. Project C: The present value of the future cash flows is $5,000,000 + $300,000, or $5,300,000. The profitabiity index is $5,300,000 ÷ $5,000,000 = 1.06. Project D: The present value of the future cash flows is $2,000,000 + $250,000, or $2,250,000. The profitabiity index is $2,250,000 ÷ $2,000,000 = 1.125. The profitability index of Project D is the highest of the four projects. However, note that the indicators do not agree. Project A and Project B have internal rates of return that are higher than that of Project D, and all three of the other projects have net present values higher than Project D's. The small size of Project D is a major cause of the conflicting data. Project D is quite a bit smaller than the other projects. If the company has limited funds to invest, Project D would be a good candidate. However, if the company has more funds available, it should select the project or combination of projects that use the greatest amount of its available capital and that provide the greatest total NPV.
Project C is not the best investment according to the profitability index. The profitability index is the present value of future positive cash flows divided by the initial investment plus the present value of future negative cash flows (if any). The present value of future positive cash flows is not given. However, it can be calculated using the information that is given, assuming there are no future negative cash flows. The net present value of a project is the present value of its future cash inflows minus the initial investment. We can calculate the present value of the future cash inflows for each project by adding together the project's NPV and the amount of the initial investment. Then the present value of the future cash inflows can be divided by the initial investment to calculate the PI for each project in order to determine which project appears to be the best investment using the profitability index.
Project A is not the best investment according to the profitability index. The profitability index is the present value of future positive cash flows divided by the initial investment plus the present value of future negative cash flows (if any). The present value of future positive cash flows is not given. However, it can be calculated using the information that is given, assuming there are no future negative cash flows. The net present value is the present value of its future cash inflows minus the initial investment. We can calculate the present value of the future cash inflows for each project by adding together the project's NPV and the amount of the initial investment. Then the present value of the future cash inflows can be divided by the initial investment to calculate the PI for each project in order to determine which project appears to be the best investment using the profitability index.
Project B is not the best investment according to the profitability index. The profitability index is the present value of future positive cash flows divided by the initial investment plus the present value of future negative cash flows (if any). The present value of future positive cash flows is not given. However, it can be calculated using the information that is given, assuming there are no future negative cash flows. The net present value of a project is the present value of its future cash inflows minus the initial investment. We can calculate the present value of the future cash inflows for each project by adding together the project's NPV and the amount of the initial investment. Then the present value of the future cash inflows can be divided by the initial investment to calculate the PI for each project in order to determine which project appears to be the best investment using the profitability index.
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