Question

Elise will open a greenhouse shop in 2021 where she will sell small plants and flowers to

      customers for their gardens. The construction of the greenhouse will cost $300,000 with

      installation cost of $25,000. She estimates that annually she will generate after-tax cash

     flows of $67,000 for 7 years. If her required rate of return is 13%, what is the project’s

     profitability index? Should she invest in this project?     

Answer 1

Profitability index = Present value of future cash flows / Initial investment

Present value of future cash flows = Cash flow* PVAF (r, n)

               where r is discounting rate and n is year or period

PV of future cash flow = 67000* PVAF ( 13% , 7)

= 67000*4.4226 = 296314.20

Initial investment = 300000+25000 = $ 325000

Profitability index is = 296314.2/325000 = 0.9117 = 0.91

Profitability index is less than one we should not invest in this project

Note : PVAF ( r%, n) = 1/1+r)^1 + 1/(1+r)^2 ……… 1/ (1+r)^n