Cori's Sausage Corporation is trying to choose between the...

Cori's Sausage Corporation is trying to choose between the following two mutually exclusive design projects: $$ \begin{array}{|rrr|} \hline \text { Year } & \text { Project I } & \text { Project II } \\ \hline 0 & -\$ 45,000 & -\$ 19,800 \\ 1 & 23,200 & 11,700 \\ 2 & 23,200 & 11,700 \\ 3 & 23,200 & 11,700 \\ \hline \end{array} $$ a. If the required return is 10 percent and the company applies the profitability index decision rule, which project should the firm accept? b. If the company applies the NPV decision rule, which project should it take? c. Explain why your answers in (a) and (b) are different.

Cori's Sausage Corporation is trying to choose between the following two mutually exclusive design projects:
$$
\begin{array}{|rrr|}
\hline \text { Year } & \text { Project I } & \text { Project II } \\
\hline 0 & -\$ 45,000 & -\$ 19,800 \\
1 & 23,200 & 11,700 \\
2 & 23,200 & 11,700 \\
3 & 23,200 & 11,700 \\
\hline
\end{array}
$$
a. If the required return is 10 percent and the company applies the profitability index decision rule, which project should the firm accept?
b. If the company applies the NPV decision rule, which project should it take?
c. Explain why your answers in (a) and (b) are different.

Key Concepts

Net Present Value (NPV)

Net Present Value is a capital budgeting measure that calculates the difference between the present value of cash inflows and the initial investment cost. It uses a discount rate to account for the time value of money. In decisions involving mutually exclusive projects, the project with the highest positive NPV is typically preferred because it is expected to add the most value to the firm.

Profitability Index (PI)

The Profitability Index is the ratio of the present value of future cash inflows to the initial investment. It provides a relative measure of profitability and is useful for comparing projects when available funds are limited. However, in cases involving mutually exclusive projects, reliance solely on the PI can lead to different decision outcomes than using NPV due to differences in project scale and investment size.

Mutually Exclusive Projects

Mutually exclusive projects refer to investment opportunities where the acceptance of one project means the rejection of the other(s). This concept is important in capital budgeting because the decision criteria (like NPV or PI) might lead to different selections based on factors such as project size, scale, and risk, necessitating careful analysis of both absolute and relative performance.

Time Value of Money

The time value of money is the principle that money available now is worth more than the same amount in the future due to its potential earning capacity. This principle is fundamental to techniques like discounting cash flows, NPV, and PI, ensuring that all cash flows are evaluated on a comparable basis by converting them into their present value equivalents.

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