Question

Your firm is considering an investment that will cost $950,000 today. The investment will produce cash flows of $400,000 in year 1, $250,000 in years 2, 3 and 4, $200,000 in year 5 and $250,000 in year 6. The discount rate that your firm uses for projects of this type is 11%. What is the investment's profitability index?

Answer 1

Investment's Profitability Index = Present Value of annual cash inflows / Initial Investment

Year	Annual Cash inflows	PVIF at 11%	Present Value of Annual Cash inflows
1	$4,00,000	0.900900	$3,60,360
2	$2,50,000	0.811622	$2,02,906
3	$2,50,000	0.731191	$1,82,798
4	$2,50,000	0.658730	$1,64,683
5	$2,00,000	0.593451	$1,18,690
6	$2,50,000	0.534640	$1,33,660
	TOTAL		$11,63,097

Investment's Profitability Index = Present Value of annual cash inflows / Initial Investment

= $11,63,097 / $950,000

= 1.22 [Rounded to 2 Decimal Places]

“Hence, Investment's Profitability Index = 1.22”