PART 3: CAPITAL BUDGETING

that this problem (and the scale problem) occurs only when companies must choose between mutually

exclusive projects. In the previous example, if the company can invest in both projects, then the analyst

should recommend that it do so. If the company must choose between two acceptable projects, it should

rely on NPV analysis to identify the better project.

9 Describe how the IRR and NPV approaches are related.

10 If the IRR for a given project exceeds a company’s hurdle rate, does that mean that the project

necessarily has a positive NPV? Explain.

11 Describe the scale problem and the timing problem. Explain the potential effects of these

problems on using IRR versus NPV to choose among mutually exclusive projects.

CONCEPT REVIEW QUESTIONS 9-5

9-6 PROFITABILITY INDEX

A final capital budgeting tool to discuss is the profitability index (PI). Like the IRR, the PI is a close cousin

of the NPV approach.

9-6a CALCULATING THE PROFITABILITY INDEX

For simple projects that have an initial cash outflow (CF 0 ) followed by a series of inflows (CF 1 , CF 2 , ...,CFn),

the PI is expressed mathematically as the present value of a project’s cash inflows divided by the absolute

value of its initial cash outflow.^8 It is defined as the present value of a project’s cash inflows divided by

the absolute value of its initial cash outflow.

Eq. 9.3 (^) PI
CF CF CF CF
CF
n
n

• 
  


• 
  


• 
  


• 
  


• 
  

  +...+
  (1 rr)(1)(1 rr)(1)+
  ||
  1
  1
  2
  2
  3
  3
  0
  The decision rule to follow when evaluating investment projects using the PI is to invest when
  the PI is greater than 1.0 (that is, when the present value of cash inflows exceeds the initial cash
  outflow) and to refrain from investing when the PI is less than 1.0. Note that if the PI is above 1.0,
  then the NPV is greater than $0. This means that the NPV and PI decision rules will always yield
  the same investment recommendation when we are simply trying to decide whether to accept or
  reject a single project.
  Does the IRR method always
  rank projects the same as the
  NPV method?
  thinking cap
  question
  LO9.6
  profitability index (PI)
  A capital budgeting tool,
  defined as the present value of
  a project’s cash inflows divided
  by the absolute value of its
  initial cash outflow
  See the concept explained
  step by step on the
  CourseMate website.
  SMART
  CONCEPTS
  8 Because the initial cash flow is usually negative, we divide by the absolute value of that cash flow in Equation 9.3.