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.

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.

jeff jeffy answered 6 months ago

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