Question

Unless stated otherwise, interest is compounded annually, and payments occur at the end of the period. Face value for bonds is $1000.

9. (10) Calculate the payback and profitability index for the following projects. The maximum payback period is 2 years and the cost of capital is 14%. If the projects are mutually exclusive, which one would you prefer? Why?

Project	Time 0	1	2	3
Coffee Bins	-1000	730	400	180
Tea Time	-1100	500	500	500

Answer 1

Payback Period for Coffee Bins = 1(730) + 0.675(270/400)

Payback Period for Coffee Bins = 1.675 years

Payback Period for Tea Time = 1(500) + 1(500) + 0.20(100/500)

Payback Period for Tea Time = 2.20 years

Profitability Index = PV of Cash Flow/(Initial Investment)

Profitability Index for Coffee Bins = 1,069.63/1000 = 1.07

Profitability Index for Tea Time = 1,160.82/1100 = 1.06

So, one would prefer project Coffee Bins as its payback period is lesser and profitability index is higher