If the discount rate is 14% and the ﬁrm has limited funds, which of the following is true?
A) The PI of project A is less than 1.0.
B) The PI of project B is less than 1.0.
C) Based on the PI rule, project A is preferable.
D) Both projects would be rejected based on the PI rule.
E) The project with the smaller initial investment always has the higher PI.

Question

Quizplus · Accepted Answer

To determine the best project, we need to calculate the PI (profitability index) for each project. PI is calculated by dividing the present value of future cash flows by the initial investment.

For Project A: 
PV of future cash flows = $11,000 
Initial investment = $10,000 
PI = 1.1

For Project B: 
PV of future cash flows = $16,000 
Initial investment = $12,000 
PI = 1.33

Based on the PI rule, we choose the project with the higher PI. Therefore, Project B is preferable over Project A. However, as the firm has limited funds, only one project can be chosen.

Therefore, the answer is not B and not E.

The PI of Project A is greater than 1.0, so answer choice A is not true.

Both projects cannot be rejected based on the PI rule, so answer choice D is not true.

Thus, the correct answer is C, as project A has a lower initial investment and a high profitability index greater than 1.0.

If the Discount Rate Is 14% and the ﬁRm Has