CMA Study Group

1 st question and answer:

When ranking two MUTUALLY EXCLUSIVE  investments with different initial amounts, management should give first priority to the project

A	that has the greater profitability index.
B	that generates cash flows for the longer period of time.
C	whose net after-tax flows equal the initial investment.
D	whose cash flows vary the least.

 

Correct answer given in online test : A.that has greater Profitability index

 

2 nd Question and answer

The recommended technique for evaluating projects when capital is rationed and there are NO MUTUALLY EXCLUSIVE  projects from which to choose is to rank the projects by

A	profitability index.
B	average rate of return.
C	internal rate of return.
D	payback.

 

Correct answer given in online test : A. Profitability index

My Doubt

The first question is about MUTUALLY EXCLUSIVE project and Second one is without that.

How is it that answer is same (Profitability index) in both cases ?

Hi Anil The main role is NPV is the best method to rank project in Screening method. (payback,IRR,NPV) While PI is derivative form NPV Both use the same formula NPV Amount while PI ratio The PI the best method for ranking project because it use ratio and deal with different amount >> opposite NPV don't deal with different amount it use just amount. lastly we use PI when ranking project in mutually exclusive best regards mohammed khattab

Mutually exclusive projects means that the acceptance of one project eliminates the others from consideration. Projects are said to be mutually exclusive when they cannot be undertaken simultaneously.

Profitability Index =Present value of future cashflows / Investment.

If PI =1 means no income...just keep your money in the bank; PI > 1 = means the project will generate an income ; PI < 1 means the project will be loss.

Well, in whatever investment we are taking, we first consider if it will be profitable. The one with greater PI is better. Then what if they have same PI then that's the time we go to next item we will consider such as IRR (which is the rate which make the NPV=0) or if we have time constraints, we will need to check the payback period (how long we have to recover our investment). Some projects are very profitable but it would take time to realize them.