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Question 12.2: Ranking Investment Alternatives SITUATION: The profitability...

Ranking Investment Alternatives
SITUATION: The profitability index concept does not apply only to a firm’s investments in projects. It can also apply to your personal investments. For example, suppose that you have just inherited $50,000 and want to invest it in ways that create as much value as possible. After researching investment alternatives, you have identified five investments that you believe will have positive NPVs. You estimate that the NPVs and PIs for these investments are as follows:

\begin{matrix} \underline{Project} &&& \underline{Investment} &&& \underline{NPV} &&& \underline{PI} \\ But \ a \ new \ car \ for \ your \ business &&& \$20,000 &&& \$10,000 &&& 1.500 \\ Buy \ a \ duplex \ apartment \ near \ campus &&& 50,000 &&& 22,500 &&& 1.450 \\ Start \ a \ small \ moving \ business &&& 25,000 &&& 10,000 &&& 1.400 \\ Invest \ in \ your \ roommate’s \ Internet \ business &&& 15,000 &&& 5,000 &&& 1.333 \\ Buy \ a \ collection \ of \ old \ comic \ books &&& 5,000 &&& 1,000 &&& 1.200 \end{matrix}

 

Which investment(s) should you choose?

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DECISION: You should invest in the duplex apartment. If you begin the selection process by choosing the new car because it has the largest PI and then work your way down the list until you reach a total investment of $50,000, you will see that you can invest in the car, the moving business, and the comic books. These three investments have a total NPV of $21,000. However, the investment in the duplex apartment alone has an NPV of $22,500. Investing in the duplex apartment will create more total value. This problem illustrates why the procedure for using PI to choose projects has four steps. Without the fourth step, which tells us to repeat the third step beginning with the second project, the third project, and so on, we would not have identified the duplex apartment as the best alternative.

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