Question

Marge Simpson Inc. has following business opportunities with following cash flow information. Assume Marge’s opportunity cost of capital is 12%.

Year	Project A	Project B
0	−$20,000	−$20,000
1	15,000	2,000
2	15,000	2,500
3	13,000	3,000
4	3,000	50,000

1. Calculate profitability index for both projects.
2. Calculate payback period for both projects.

Answer 1

profitability index = Total Present value of Cash Inflows/ otal Present value of Cash Outflows

Year	Cash Flow Project A ($)	PVIF @ 12%	PV Project A ( Cash Flow * PVIF) ($)	Cash Flow Project B ($)	PV Project B ( Cash Flow * PVIF) ($)
0	-20000	1	-20000	-20000	-20000
1	15000	.893	13395	2000	1786
2	15000	.797	11955	2500	1992.50
3	13000	.712	9256	3000	2136
4	3000	.636	1908	50000	31800

PI of A = (13395+11955+9256+1908)/20000

= 1.83

PI of B = (1786+1992.50+2136+31800) / 20000

=1.89

Payback Period

Project A

Initial Outlay = $ 20,000

Cash flow for 3 years = $ 7500

Balance Outlay = 20000-7500 = 12,500

cash Flow for year 4= 50000

Therefore, payback period = 3 year + 12500/50000

=3.25 years

Project B

Initial Outlay = $ 20,000

Cash flow for 1 year = $ 15,000

Balance Outlay = 20000-15000 = 5000

cash Flow for year 2= 15000

Therefore, payback period = 1 year + 5000/15000

=1.33 years