2) We generally assume that the firm will undertake any project with a positive NPV since it can always borrow at the rate used in the NPV formula to finance the profitable venture This is somewhat unrealistic in the real world where borrowing takes time and has many transaction costs as well as interest costs. As such, firms are often constrained in their investment decision by having limited funds They often have to figure out a way of choosing between several positive NPV projects One popular method is to use the Profitability Index: P.I. - PV (Future Earnings) / (PV of Cost) Note, it is PV of future, positive cash flows divided by (PV, if necessary) project cost (not NPV/cost). This index is supposed to allow us to choose the projects that have the greatest 'bang for the buck'. It works well most of the time. Try it in this scenario: The firm cannot invest more than 200 of its money in new projects in any period. It must chose between these projects given a discount rate of 5% (where CF x means cash flow at time x. 0 is today, 1 is in 1 yr. etc. Negative CF is the cost.): CF 0 200 120 80 CF 1 500 200 200 CF 2 200 300 200 Construct a table that includes the projects, their NPV and their Profitability Indexes. Based solely on NPv, which project (s) would you chose? Now use the P.I. to suggest an alternative investment strategy. (Hint-Rank them according to their PI and see how many you can afford.) Show that the NPV of your new strategy is better than your initial choice