Question

Use the following information for the next two questions. You are creating a cash flow project for your new venture, CBD IPA, a cannabis-infused beer and have made the following assumptions for the business:

• First year sales of 10,000 cans, rising by 10% each year
• Price per unit of $4.00 each, rising by 2% per year
• Operating expense equals first year sales revenue and rises 10% per year

1. What is the projected sales revenue of CBD IPA in year 3 (6 points)?

  

1. What is the operating income of CBD IPA in Year 4 (6 points)?

1. Define the profitability index and explain how it may be used a criterion for determining whether to pursue an investment or project (8 points).

Answer 1

1.

Sales revenue in year 3 = Number of canes sales x price per can

                                       = 10,000 x (1.1)2 x $ 4 x (1.02)2

                                                            = 10,000 x 1.21 + $ 4 x 1.0404

                                       = 12,100 x $ 4.1616

                                     = $ 50,355.36

2.

Sales revenue in year 4 = Number of canes sales x price per can

                                       = 10,000 x (1.1)3 x $ 4 x (1.02)3

                                                            = 10,000 x 1.331 + $ 4 x 1.061208

                                       = 13,310 x $ 4.244832

                                     = $ 56,498.71392

Operating expenses in year 4 = First year sales revenue x (1+0.1)3

                                              = $ 10,000 x $ 4 X (1.1)3

                                               = $ 10,000 x $ 4 X 1.331

                                                = $ 53,240

Operating income in year 4 = Sales revenue – Operating expenses

                                           = $ 56,498.71392 - $ 53,240 = $ 3,258.71392 or $ 3,258.71

Profitability index refers to the ratio between discounted benefit to the discounted cost of a project.

It is a useful financial tool to decide the acceptability of investment by measuring the present value of benefit of the project obtained from every dollar invested.

Profitability index greater than one indicates that present value of cash inflows is higher than investment and the project earns a profit and hence acceptable.

Profitability index equal to one reveals the breakeven state of the project. Project is in a no profit and no loss state and all the expenses are covered without generating any profit.

Profitability index less than one points out that present value of cash inflows is less than the amount invested and the project incurring a loss and hence not acceptable.