Solution of Profitability

1. Solution of Profitability

So as we mentioned, this should have been a relatively straightforward assignment in this particular tab here. So let's calculate now the profitability index. Equals, let's open up a bracket, we're gonna take the NPV here, we're gonna want to add the initial investment, so we're gonna put in a minus signs, so if we subtract this negative number here, that'll be equivalent to adding, we're gonna close the bracket and we're gonna divide by the initial investment, but again, let's put in a minus sign so that we can flip the sign of this to positive and we're gonna hit Enter there, and we get 1.67. It's our profitability index. We have a check box over here and it's also showing 100%. So let's go ahead and calculate the profitability index, similarly down here equals we're gonna open up the bracket NPV minus this initial investment here, close the bracket and divide by negative that initial investment there we're gonna hit enter now and we get the second profitability index. So it's great that we've calculated these figures, but more importantly, how would we use them to help us. Well, first of all, if we look at these two projects, very similar NPVs, in fact, if we were just using NPV, it might be hard to choose between the projects. Now we look at the profitability index, both profitability indexes are higher than one, so we know that both projects are creating value, but this one is substantially higher at 1.67 versus this one at 1.07, so we would end up choosing project A over project B, if we only had sufficient capital for one project.

2. Let's practice!

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