Question

1. ABC is considering a new project. You have the following information:

Time	0	1	2	3	4
Cash Flow	-100	25	60	45	35

The cost of capital is 11%.   Find the profit index and payback period for the project. Assume the maximum payback is 2 years. Do they accept the project? Explain.

Answer 1

Profitability index is a ratio of the discounted cash flow to the initial cash flow of the project. It is calculated using the below formula:

Profitability Index= PV of future cash flows/Initial investment

Net present value is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$100
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the forth cash flow cash flow, press the NPV button and enter the interest rate of 11%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The present value of cash flows is $27.18.

Profitability Index= $27.18/ $100 = 0.27.

Payback period is the time period taken to recover the initial cost of investment and it is calculated using the formula below:

Payback period=full years until recovery + unrecovered cost at the start of the year/cash flow during the year

Payback period= 2 years + 15/ 45

                              = 2 years + 0.34 = 2.34 years.

The project should be accepted using the net present value since it results in a positive net present value. The project should be rejected based on the payback period since the project’s payback exceeds maximum payback period of 2 years.