Suppose your firm is considering investing in a project with the cash flows shown as follows,that the required rate of return on projects of this risk class is 8 percent,and that the maximum allowable payback and discounted payback statistic for the project are three and three and a half years,respectively. Use the PI decision rule to evaluate this project; should it be accepted or rejected?
A) −0.39 percent, reject
B) 0.39 percent, accept
C) 38.88 percent, reject
D) 38.88 percent, accept

Question

Suppose your firm is considering investing in a project with the cash flows shown as follows,that the required rate of return on projects of this risk class is 8 percent,and that the maximum allowable payback and discounted payback statistic for the project are three and three and a half years,respectively.  Use the PI decision rule to evaluate this project; should it be accepted or rejected?
A) −0.39 percent, reject 
B) 0.39 percent, accept 
C) 38.88 percent, reject 
D) 38.88 percent, accept

Quizplus · Accepted Answer

PI (Profitability Index) is the ratio of the present value of future cash flows to the initial investment.

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

PV of future cash flows = CF1/(1+r)^1 + CF2/(1+r)^2 + ... + CFn/(1+r)^n, where CF is the cash flow and r is the discount rate.

PV of future cash flows = -5000 + 1000/1.08 + 2000/1.08^2 + 3000/1.08^3 + 4000/1.08^4

PV of future cash flows = 921.06

PI = 921.06 / 5000 = 0.184

Since the PI is less than 1, the project should be rejected. Therefore, option D is the correct answer.

Suppose Your Firm Is Considering Investing in a Project with the Cash