Question

You are offered an investment with returns of $ 1,200 in year 1, $ 4,704 in year 2, and $ 4,745 in year 3. The investment will cost you $ 7,535 today. If the appropriate Cost of Capital (quoted interest rate) is 11.1 %, what is the Profitability Index of the investment?

Answer 1

Profitability Index of the investment

Year	Annual Cash Flow ($)	Present Value factor at 11.10%	Present Value of Cash Flow ($)
1	1,200	0.900090	1,080.11
2	4,704	0.810162	3,811.00
3	4,745	0.729219	3,460.14
TOTAL			8,351.25

Profitability Index of the investment = Present Value of annual cash inflows / Initial Investment

= $8,351.25 / $7,535

= 1.11

“Hence, the Profitability Index of the investment will be 1.11”

NOTE    

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.