Question

The firm is considering the purchase of a new device that costs €6,000. Assume a required...

The firm is considering the purchase of a new device that costs €6,000. Assume a required rate of return of 12% and the following cash flow schedule:

Year 1

€3,000

Year 2

2,000

Year 3

2,000

Calculate the profitability index of the investment project and Would the acceptance of the project result in added value for the firm? Explain.

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Answer #1

The profitability index of device is computed as shown below:

= Present value of future cash flows / Initial investment

Present value is computed as follows:

= Future value / (1 + r)n

= € 3,000 / 1.12 + € 2,000 / 1.122 + € 2,000 / 1.123

= € 5,696.519679

So, the PI will be computed as follows:

= € 5,696.519679 / € 6,000

= 0.9494 Approximately

Since the PI of the device is less than 1, hence it implies that the NPV of the device is negative and hence the project shall not be accepted since it will lead to deterioration in the value of the firm.

Feel free to ask in case of any query relating to this question     

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