Question

Consider the following projects: Cash Flows ($) Project C0 C1 D –10,900 21,800 E –20,900 36,575 Assume that the projects are mutually exclusive and that the opportunity cost of capital is 8%. a. Calculate the profitability index for each project. (Do not round intermediate calculations. Round your answers to 2 decimal places.) Project Profitability Index D E b-1. Calculate the profitability-index using the incremental cash flows. (Do not round intermediate calculations. Round your answer to 2 decimal places.) Profitability-index b-2. Which project should you choose? Project D Project E

Answer 1

a.

Profitability Index for project D = [$21,800 / (1 + 8%)] / $10,900

= $20,185.19 / $10,900

= 1.85

Profitability Index for project D is 1.85.

Profitability Index for project E = [$36,575 / (1 + 8%)] / $20,900

= $33,865.74 / $20,900

= 1.62

Profitability Index for project D is 1.62.

b-1

Incremental Cash outflow = $20,900 - $10,900

= $10,000

Incremental Cash flow is $10,000.

Incrematal cash inflow = $36,575 - $21,800

= $14,775.

Incrematal cash inflow is $14,775.

Profitability Index for incremental cash flow = [$14,775 / (1 + 8%)] / $10,000

= $13,680.56 / $10,000

= 1.37

Profitability Index for incremental cash flow is 1.36.

Since, profitability index for project D is higher than  profitability index for project E, so, project D should be accepted.