Question

Tanjong Inc. is considering two mutually exclusive projects, A and B. Project A costs
RM95,000 and is expected to generate RM65,000 in year one and RM75,000 in year
two. Project B costs RM120,000 and is expected to generate RM64,000 in year one,
RM67,000 in year two, RM56,000 in year three, and RM45,000 in year four. Tanjong
Inc.'s required rate of return for these projects is 10%. Calculate the profitability index
for Project A and Project B. Which project is better?

Answer 1

Project A costs RM95,000 and is expected to generate RM65,000 in year one and RM75,000 in year two.
Project B costs RM120,000 and is expected to generate RM64,000 in year one, RM67,000 in year two, RM56,000 in year three, and RM45,000 in year four. Tanjong Inc.'s required rate of return for these projects is 10%.
Profitability index PI = NPV/initial investment
For Project A PI = (-95,000 + 65,000/1.1 + 75,000/1.1^2)/95,000 = 0.275
For Project B PI = (-120,000 + 64,000/1.1 + 67,000/1.1^2 + 56,000/1.1^3 + 45,000/1.1^4)/120,000 = 0.553
So, project B is better.