Question

In: Finance

A firm is considering a project that requires an initial investment of $250,000. The life of...

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.

Solutions

Expert Solution

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:

  • Press the CF button.
  • CF0= -$250,000. It is entered with a negative sign since it is a cash outflow.
  • 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 cost of capital of 8%.
  • Press enter after that. Press the down arrow and CPT buttons to get the net present value.

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.


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