Question

# A firm is considering investing in a 15-year capital budgeting project with a net investment of...

A firm is considering investing in a 15-year capital budgeting project with a net investment of \$14 million. The project is expected to generate annual net cash flows each year of \$2 million and a terminal value at the end of the project of \$10 million. The firm’s cost of capital is 9 percent and marginal tax rate is 40%. What is the profitability index of this investment?

0.35
0.78
2.86
1.54
1.35

The profitability index of project A is computed as shown below:

= Present value of future cash flows / Initial investment

Present value is computed as follows:

= Future value / (1 + r)n

= \$ 2 million / 1.091 + \$ 2 million / 1.092 + \$ 2 million / 1.093 + \$ 2 million / 1.094 + \$ 2 million / 1.095 + \$ 2 million / 1.096 + \$ 2 million / 1.097 + \$ 2 million / 1.098 + \$ 2 million / 1.099 + \$ 2 million / 1.0910 + \$ 2 million / 1.0911 + \$ 2 million / 1.0912 + \$ 2 million / 1.0913 + \$ 2 million / 1.0914 + \$ 2 million / 1.0915 + \$ 10 million / 1.0915

= \$ 18.86675727 million

So, the profitability index is computed as follows:

= \$ 18.86675727 million / \$ 14 million

= 1.35 Approximately

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