A firm is considering four projects with the following PIs, NPVs, and Costs
Project A: PI of 1.3, NPV of $3,600, and cost of $12,000; Project B: PI of 1.4, NPV of $5,600, and cost of $14,000; Project C: PI of 1.5, NPV of $5,000, and cost of $10,000; Project D: PI of 2.1, NPV of $8,800, and cost of $8,000. Rank the projects from best to worst in terms of their NPVs. Now rank the projects from best to worst in terms of their PIs.
What will be an ideal response?
Answer: Ranking by NPV, we get D: $8,000; B: $5,600; C: $5,000; and A: $3,600.
Ranking by PI, we get D: 2.1; C: 1.5; B: 1.4; and A: 1.3.
Explanation: If we could only spend, say, $20,000, then Project D looks great since it has the highest PI (the biggest bang for our limited bucks), and yet costs only $8,000. Our next pick would then be Project C, based on the PI. Although it would add another $10,000 to our costs to boost the total to $18,000, we would still be within our limit. Then, we would use the PI to look at Project B, but we would reject it since its cost of $14,000 would push us over our limit. We would then look at Project A, and we would also reject it since its cost of $12,000 would also push us over the limit. The PI is simply a guide that tells us which projects to look at in what order when you have a capital budgeting cost limit.
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