Sunshine Corporation is considering several long-term investments. Management wants to accept the two best projects, given the following data:
A B C D E
Present value of
net cash inflows . . . . . . . . $24,000 $44,000 $15,000 $30,000 $50,000
Investment cost . . . . . . . . . . 20,000 40,000 16,000 24,000 41,000
2. Which projects are acceptable using the profitability index as a screening tool?
3. What would be the ranking of the acceptable projects according to the profitability indexes?
4. Interpretive Question: What additional information would be needed to screen and rank the projects using the internal rate of return method? What are the decision rules using the IRR method for screening and ranking capital budgeting projects?
1. Determine the net present value and the profitability index for each project.
NPV= PV of net cash inflows - Investment cost
Profitability Index = PV of net cash inflows / Investment Cost
Project A B C D E
NPV 4000 4000 -1000 6000 9000
Profitability Index 1.20 1.10 0.9375 1.25 1.2195
2. Which projects are acceptable using the profitability ...
The problem illustrates use of profitability index for screening projects for capital investment. It explains how to calculate the profitability index and how to rank the projects based on that. The post also touches on the question of why it was not feasible to use IRR in this particular case.