Question

Consider the following two mutually exclusive projects:

Year	Cash Flow (A)	Cash Flow (B)
0	–$218,917	–$16,419
1	25,700	5,985
2	53,000	8,370
3	58,000	13,931
4	420,000	8,655

Whichever project you choose, if any, you require a 6 percent return on your investment.

What is the profitability index for Project A?

What is the profitability index for Project B?

Answer 1

Profitability Index= PV of future cash flows/Initial investment

Project A

PV of future cash flows is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$218,917.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the third cash flow cash flow, press the NPV button and enter the interest rate.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The present value of cash flows is $233,875.35

Profitability Index= $233,875.35/ $218,917= 1.07.

Project B

PV of future cash flows is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$16,419.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the third cash flow cash flow, press the NPV button and enter the interest rate.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The present value of cash flows is $15,228.80.

Profitability Index= $15,228.80/ $16,419= 0.93.