Question

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

Answer 1

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

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