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:
- Determine incremental PI, you may subtract project 1 cash flows from project 2 cash flows to solve incremental PI.
- Make decision for these projects.
Solution:
- 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
- Decision
Because the Profitability Index (PI=2.52) on the incremental cash flows is greater than 1, we should choose the project 1.
Source:
- Phnom Penh HR
- Mcgraw-Hill – Fundamentals Of Corporate Finance