Question

What is the profitability index of the proposed project if the discount rate is 6%?

Year 0 CF = -$20,000

Year 1 CF = $3,000

Year 2 CF = $4,000

Year 3 CF = $5,000

Year 4 CF = $6,000

Year 5 CF = $7,000.

Options:

A) 1.63

B) 2.03

C) 1.03

D) 0.03

Answer 1

Profitability index = NPV + initial investment/ initial investment

First let us calculate the NPV of the proejct :

The NPV is : $571.64

CFO = ( $20,000)

CF1 = $3,000

CF2= $ 4,000

CF3= $5,000

CF4 = $6,000

CF5 = $7,000

The discount rate is 6%, so the NPV is

= $571.64

Alternatively ,

( $20,000) + $3,000/1.06 + $4,000/1.06^2+ $5,000/1.06^3 + $6,000/1.06^4 + $7,000/1.06^5

So, the PI is :

=( $571.64 + $20,000)/ $20,000

= 1.0286

= 1.03 ( rounded off to two decimal places)

So, the correct option is option C.