Question

The Michener Corporation is trying to choose between the following two mutually exclusive design projects: 63000

Answer 1

The Michener Corporation Company must choose Project 2 as its more profitable. Here's why,

SOLUTION: -

Profitability Index PI = ( PV of future cash flows)  / Initial investment

PV of future cash flows = Σ CFn / ( 1 + r )ⁿ, where, CFn is the cash flow for year.

Required return = r = 11%

For Project 1,

PV of future Cash Flows

= 32000 / ( 1+0.11 ) + 32000 / ( 1+0.11 )² + 32000 / ( 1 + 0.11 )³ = $78198.87

Initial Investment = $63000

⇒ PI = 78198.87 / 63000 = 1.24

For Project 2,

PV of future Cash Flows

= 9750 / ( 1 + 0.11 ) + 9750 / ( 1 + 0.11 )² + 9750 / ( 1 + 0.11 )³ = $23826.21

Initial Investment = $18100

⇒P or  profitability index = 23826.21 / 18100

= 1.32

Therefore, According to profitability index rule, project with highest PI should be selected. Hence, Project 2 should be selected.

To know more about profitability index, check the given links.

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