Exercise-5 (Present value index – ranking investment projects)

The management of National company is considering three competing investments – investment P, investment Q and investment R. The information about the requirement of initial amount of investment, present value of net cash inflow and net present value of all three investments is given below:

Required:

Choose the most desirable proposal using present value index (profitability index).

Solution:

As each investment requires a different initial investment, the proposals would be ranked using present value index (also called profitability index).

Present value index = Present value of cash inflows/Initial investment

Proposal P: $36,000/$35,000 = 1.03

Proposal Q: $21,000/$20,000 = 1.05

Proposal R: $12,000/$11,000 = 1.09

Proposal R is the most desirable proposal because it has the highest present value index.