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Profitability Index (PI) for Mutually Exclusive Project

Profitability Index (PI) for Mutually Exclusive  Project

Mutually exclusive project is different from independent project. For mutually exclusive project, we can accept project A or B or deny both, but we cannot accept both projects.

We may solve mutually exclusive projects using PI with following way:

  • Compute incremental PI solved via cash flows from project A minus project B,
  • If incremental PI > 1, so choose project A.

Example:

ABC Corporation applies a 12 percent discount rate to two investment opportunities, and we assume both projects are mutually exclusive projects.

Required:

  1. Determine incremental PI, you may subtract project 1 cash flows from project 2 cash flows to solve incremental PI.
  2. Make decision for these projects.

Solution:

  1. Incremental PI

Subtracting project 1 cash flows from project 2 cash flows gives the following results:

Cash flow (Year 0) =-20-(-10)=-10

Cash flow (Year 1)= 70 -15 =55

Cash flow (Year 2) =10-40=-30

Incremental PV (project 1- project 2) = 55/(1+12%)^1-30/(1+12%)^2=25,200,000

Incremental Initial investment (project 1 – project 2)=10,000,0000

Incremental PI = 25,200,000/10,000,000=2.52

  1. Decision

Because the Profitability Index (PI=2.52) on the incremental cash flows is greater than 1, we should choose the project 1.

Source:

  1. Phnom Penh HR
  2. Mcgraw-Hill – Fundamentals Of Corporate Finance

 

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