Question

Assume the following information for three investment proposals:

Proposal A Proposal B Proposal C
Investment required $ (200,000 ) $ (255,000 ) $ (350,000 )
Present value of cash inflows 220,000 315,000 420,000
Net present value $ 20,000 $ 60,000 $ 70,000

Based on the profitability index, which of the following statements is true?
a. Proposal C is preferable to Proposal B
b. Proposal A is preferable to Proposal C
c. Proposal A is preferable to Proposal B
d. Proposal B is the highest ranked proposal among the three choices.

Answer 1

The correct answer is option d. Using the profitability index, Proposal B is found to have the highest value, with a profitability index of 1.24, indicating it is the most efficient proposal per dollar invested. Therefore, Proposal B is the highest ranked proposal among the three choices.

Step-by-step explanation:

When assessing investment proposals using the profitability index, we're interested in evaluating which proposal provides the most value for each dollar invested. The profitability index is calculated by dividing the Present Value of Cash Inflows by the Investment Required.

Here is the profitability index for each proposal:

• Proposal A: $220,000 / $200,000 = 1.10
• Proposal B: $315,000 / $255,000 = 1.24
• Proposal C: $420,000 / $350,000 = 1.20

Proposal B has the highest profitability index at 1.24, which implies that for every dollar invested, it generates $1.24 in present value terms. Thus, it is the most efficient investment of the three in terms of the value it creates per dollar invested.

So, based on the profitability index, the correct answer to the question is d. Proposal B is the highest ranked proposal among the three choices.