Consider the following two projects: PROJECT PROJECT A1 A2 3 (a) Calculate the p

Question

Consider the following two projects:

PROJECT PROJECT

A1 A2

3

(a) Calculate the profitability index for A1 and A2 at an interest rate of 6%.

(b) Determine which project(s) you should accept:

(1) If you have enough money to undertake both

   (2) If you could take only one due to a budget limit

PLEASE SHOW ALL WORK TO GET RATING/POINTS

Investment Required at n=0 $900,000 $1,200,000 1 $400,000 $200,000 2 $340,000 $300,000

3

$300,000 $350,000 4 $240,000 $440,000 5 $200,000 $400,000 6 $150,000 $350,000

Explanation / Answer

Hi,

Please find the answer as follows:

Part A:

Profitability Index = Present Value of Cash Inflows/Initial Investment

Project A1

Present Value of Cash Inflows = 400000/(1+.06)^1 + 340000/(1+.06)^2 + 300000/(1+.06)^3 + 240000/(1+.06)^4 + 200000/(1+.06)^5 + 150000/(1+.06)^6 = 1377141.26

Profitability Index = 1377141.26/900000 = 1.53

Project A2

Present Value of Cash Inflows = 200000/(1+.06)^1 + 300000/(1+.06)^2 + 350000/(1+.06)^3 + 440000/(1+.06)^4 + 400000/(1+.06)^5 + 350000/(1+.06)^6 = 1643705.60

Profitability Index = 1643705.60/1200000 = 1.37

Part B:

1) Both the projects should be undertaken as the both have PI > 1.

2) Project A1 should be undertaken as it has a higher PI in comparison to A2.

Thanks.

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