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Profitability index

OOgoegbunam11y ago
Tutor, I refer to Bpp MCQ no 37.5. NB Co is faced with an immediate capital constraint of $100 million available to invest. It is considering investing in 4 divisible projects: $m Initial cost NPV Project 1 40 4 Project 2 30 5 Project 3 50 6 Project 4 60 5 What is the NPV generated from the optimum investment programme? My question is this: why is it that (npv + initial cost) / initial cost was used to determine the profitability index instead of the regular formula: PV / initial cost? Thank you Ogo
John MoffatJohn MoffatTutor11y ago#1
It does not matter - there are two ways of defining it and either way will get the marks. (and, of course, any decisions will be the same whichever definition you use)
OOgoegbunam11y ago#2
John, Thanks for your quick response.... I've tried it, the ranking is not the same, especially in MCQ the answer differs.. Kindly review Bpp revision kit, question no 37.5 ( NB Co) you will understand me better. Thanks Ogo
John MoffatJohn MoffatTutor11y ago#3
Of course the ranking is exactly the same - it always will be!!! However I have just read again what you typed and it was wrong. The normal formula is NPV / initial cost. In this question it gives 1) 0.10 ; 2) 0.17; 3) 0.12; 4) 0.08 The alternative is to use PV / initial cost. (Since NPV = PV - initial cost, then PV = NPV + initial cost). Using this (which is what BPP do here) gives 1) 1.10; 2) 1.17; 3) 1.12; 4) 1.08 The ranking remains the same. It always will - there is only one correct ranking!!
OOgoegbunam11y ago#4
Many thanks John, your absolutely right. I've seen my mistake.
John MoffatJohn MoffatTutor11y ago#5
You are welcome :-)
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