A company is considering two projects, Project A and Project B. The following information is available for each project: Project AProject B Investment $500,000$2,000,000Net present value of cash flows$600,000$800,000Calculate the profitability index for each project. Based on the profitability index, which project, if any, should the company pursue and why?
What will be an ideal response?
| Calculation | Profitability Index |
| Project A... | $600,000/$500,000 | 1.2 |
| Project B... | $800,000/$2,000,000 | .4 |
Since a higher profitability index suggests a more desirable project, Project A should be selected. Note:
A profitability index less than 1.0 indicates an investment with a negative net present value. In making capital investment decisions, we should invest if the NPV is positive; we should not invest if the NPV is negative. Since Project A is above 1.0, it should be selected.
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