In: Finance
A firm is considering a project that requires an initial investment of $250,000. The life of this project is five years. Cash flows for each year are estimated as follows:
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
$80,000 | $120,000 | $160,000 | $40,000 | -$90,000 |
The cost of capital of this project is 8%. Calculate the profitability index and make a decision.
Profitability index is calculated using the below formula:
Profitability Index= NPV + Initial investment/ Initial investment
Net present value is calculated using a financial calculator by inputting the below:
The net present value of cash flows is $22,116.60.
Profitability Index= $22,116.60 + $250,000/ $250,000
= $272,116.60/ $250,000
= 1.0885.
The project should be accepted since the project has a profitability index greater than 1.
In case of any query, kindly comment on the solution.