Profitability Index versus NPV. Consider these two projects:

Question

Project C 0 C 1 C 2 C 3

A

-$36

$20

$20

$20

B

- 50

25

25

25

A. Which project has the higher NPV if the discount rate is 10 percent?

B. Which has the higher profitability index?

C. Which project is most attractive to a firm that can raise an unlimited amount of funds to pay for its investment projects? Which project is most attractive to a firm that is limited in the funds it can raise?

Answer 1

A. NPV of Project A is = -36 + 20/(1.1)^1+20/(1.1)^2+20/(1.1)^3 = $13.74

    NPV of Project B is = -50 + 25/(1.1)^1+25/(1.1)^2+25/(1.1)^3 = $12.17

B. Profitability index for Project A is = (36+13.74)/36 = 1.38

    Profitability index for Project B is = (50+12.17)/50 = 1.24

C. In both scenarios you would select Project A because of its higher NPV. In case you have unlimited resources you can earn $75 in cash flow from project B as opposed to Project A which shows a total cash stream of $60. However when you choose Project A you will be left with $14 which can be invested at the hurdle rate of 10% thus giving a higher NPV compared to Project B.