Ranking of the projects using the profitability index.
|
PROJECT |
NET INVESTMENT |
NET PRESENT VALUE |
PROFITABILITY INDEX |
RANKING OF PROJECTS |
|
PI = 1+(NPV/Initial investment Required |
||||
|
A |
$200,000 |
$22,000 |
1.11 |
2 |
|
B |
$275,000 |
$21,000 |
1.07 |
6 |
|
C |
150,000 |
6,000 |
1.04 |
7 |
|
D |
$190,000 |
($19,000) |
0.9 |
10 |
|
E |
$500,000 |
$40,000 |
1.08 |
5 |
|
F |
$250,000 |
$30,000 |
1.12 |
3 |
|
G |
$100,000 |
$7,000 |
1.07 |
8 |
|
H |
$200,000 |
$18,000 |
1.09 |
4 |
|
I |
$210,000 |
$4,000 |
1.02 |
9 |
|
J |
$250,000 |
$35,000 |
1.14 |
1 |
The profitability index decision rule states that any investment project with a profitability index of more than one is acceptable to be undertaken while a project with a profitability index of less than one is not acceptable ( Bierman & Smidt, 2012). A project with a profitability index of zero puts an investor at an indifference point as to whether undertake or not undertake a particular project. Therefore, considering the funds limit available of $1.2 million, nine projects with a PI of more than one are acceptable except project D since it has a PI of less than one. Therefore, due to fund limit projects J, A, F, H will be undertaken to completion first as they have the highest PI. However, only a 60% of Project E will be undertaken.
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The net present value decision criterion states that all investment projects with a positive net present value are acceptable ( Bas, 2013) . Therefore, using net present value technique, projects A,B,C,E,F,G,H,I,J are all acceptable. However, project D is not acceptable in this case because it has a negative net present value.
In case the available funds are reduced to $1,000,000, the list of acceptable projects based on the profitability index will not change. However, when the funds limit is reduced to $1,000,000, only a 20% of project E will be undertaken.
The opportunity cost of the eliminated $200,000 is that 40% of project E will be foregone.
References
Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects . Routledge.
Bas, E. (2013). A robust approach to the decision rules of NPV and IRR for simple projects. Applied Mathematics and Computation , 219 (11), 5901-5908.
