Question

Suppose a company has proposed a new 5-year project. The project has an initial outlay of $178,000 and has expected cash flows of $32,000 in year 1, $40,000 in year 2, $57,000 in year 3, $68,000 in year 4, and $74,000 in year 5. The required rate of return is 14% for projects at this company. What is the profitability index for this project? (Answer to the nearest hundredth, e.g. 1.23)

Answer 1

Profitability Index= PV of future cash flows/Initial investment

Project A

PV of future cash flows is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$178,000.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the required rate of return of 14%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The present value of cash flows is -$1,983

Profitability Index= -$1,983/ $178,000 = -0.01.

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