In: Finance
The Arbors at Los Brisos and Ranch Pointe are being considered for investment. Our initial investment in the two properties are:
The Arbors at Los Brisos $2,000,000
Ranch Pointe $2,750,000
The cost of capital for our firm is 12%
We need to rank the projects according to the profitability
index.
The Arbors at Los Brisos Ranch Pointe
Initial Investment -$2,000,000
-$2,750,000
Year 1 $450,000 $300,000
Year 2 $600,000 $500,000
Year 3 $750,000 $750,000
Year 4 $700,000 $875,000
Year 5 $700,000 $950,000
Which of the two should be ranked higher based upon profitability
index?
The Arbors at Los Brisos |
||
Ranch Pointe |
||
Neither because the profitability is less than 1.0 |
||
Not enough information available to determine. |
Answer: The Arbors at Los Brisos should be ranked higher based upon profitability index.
Initial investment for "The Arbors at Los
Brisos"=$2,000,000
Initial investment for "Ranch Pointe"=$2,750,000
Cash flows for "The Arbors at Los Brisos":
Year 0:$2,000,000
Year 1:$450,000
Year 2:$600,000
Year 3:$750,000
Year 4:$700,000
Year 5:$700,000
Profitability index=(Present value of future cash flows)/(Initial investment)
Present value of future cash flows= (Cash flow in year
1)/(1+cost of capital)^1+(Cash flow in year 2)/(1+cost of
capital)^2+(Cash flow in year 3)/(1+cost of capital)^3+(Cash flow
in year 4)/(1+cost of capital)^4+(Cash flow in year 5)/(1+cost of
capital)^5
Present value of future cash
flows=450000/(1+12%)^1+600000/(1+12%)^2+750000/(1+12%)^3+700000/(1+12%)^4+700000/(1+12%)^5
=450000/(1.12)^1+600000/(1.12)^2+750000/(1.12)^3+700000/(1.12)^4+700000/(1.12)^5
=450000/1.12+600000/1.2544+750000/1.404928+700000/1.57351936+700000/1.762341683
=401785.7143+478316.3265+533835.1859+444862.6549+397198.799
=2255998.681
Profitability index for "The Arbors at Los
Brisos"=2255998.681/2000000=1.127999341 or 1.23 (Rounded to two
decimal places)
Cash flows for "Ranch Pointe":
Year 0:$2,750,000
Year 1:$300,000
Year 2:$500,000
Year 3:$750,000
Year 4:$875,000
Year 5:$950,000
Present value of future cash
flows=300000/(1+12%)^1+500000/(1+12%)^2+750000/(1+12%)^3+875000/(1+12%)^4+950000/(1+12%)^5
=300000/(1.12)^1+500000/(1.12)^2+750000/(1.12)^3+875000/(1.12)^4+950000/(1.12)^5
=300000/1.12+500000/1.2544+750000/1.404928+875000/1.57351936+950000/1.762341683
=267857.1429+398596.9388+533835.1859+556078.3186+539055.513
=2295423.099
Profitability index=(Present value of future cash flows)/(Initial
investment)
=2295423.099/2750000=0.834699309 or 0.83 (Rounded to two decimal
places)
The Arbors at Los Brisos should be ranked higher based on profitability index because its profitability index is 1.23 which is higher than that of Ranch Pointe.