Question

Given the discount rate and the future cash flow of each project listed in the following​ table,

use the PI to determine which projects the company should accept.

What is the PI of project​ A?

Enter your answer in the answer box and then click Check Answer.

  

Cash Flow	Project A		Project B
Year 0	−​$2,000,000		−​$2,600,000
Year 1	​$400,000		​$1,300,000
Year 2	​$550,000		​$1,150,000
Year 3	​$700,000		​$1,000,000
Year 4	​$850,000		​$850,000
Year 5	​$1,000,000		​$700,000
Discount rate	6​%		15​%

Answer 1

The profitability index of project A is computed as shown below:

= Present value of future cash flows / Initial investment

Present value is computed as follows:

= Future value / (1 + r)ⁿ

= $ 400,000 / 1.06 + $ 550,000 / 1.06² + $ 700,000 / 1.06³ + $ 850,000 / 1.06⁴ + $ 1,000,000 / 1.06⁵

= $ 2,875,127.817

So, the profitability index of project A will be computed as follows:

= $ 2,875,127.817 / $ 2,000,000

= 1.4376 Approximately

The profitability index of project B is computed as shown below:

= Present value of future cash flows / Initial investment

Present value is computed as follows:

= Future value / (1 + r)ⁿ

= $ 1,300,000 / 1.15 + $ 1,150,000 / 1.15² + $ 1,000,000 / 1.15³ + $ 850,000 / 1.15⁴ + $ 700,000 / 1.15⁵

= $ 3,491,530.206

So, the profitability index of project B will be computed as follows:

= $ 3,491,530.206 / $ 2,600,000

= 1.3429 Approximately

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