A Profitability Index Can Be Used to Rank Investment Proposals

question 61

Essay

A profitability index can be used to rank investment proposals.
Required:
A.Define the profitability index.
A.The profitability index equals the present value of a project's cash inflows divided by the initial investment.
B.Both projects provide a return greater than the hurdle rate and both are acceptable.It is not possible to say which one is better.The profitability index provides a ratio that is not influenced by the size of the project-a limitation of net-present-value (NPV)analysis.Thus,a project that has a greater NPV and a greater profitability index generally will be more attractive than another project against which it is being compared.
B.Two projects are under consideration.Project I has a net present value of $20,000 whereas project II has a net present value of $200,000.Which project is better? Explain.What weakness in a net-present-value analysis does the profitability index address?

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Definitions:

Retired

In accounting and finance, this term often indicates that an asset has been taken out of service or that a debt instrument, like a bond, has been paid off and is no longer in circulation.

Bonds Payable

Bonds payable refers to the amount of money a company owes to holders of its bonds, representing a long-term debt obligation.

Credit Cash

An accounting entry that represents an increase in cash or cash equivalents, indicating funds being added to the company’s assets.

Bond Interest Expense

The cost incurred by an issuer of bonds for the interest required to be paid to bondholders.