Question

BMW is taking on new project and came up with the following projected cash flows. Compute a) Profitability Index b) NPV c) IRR for the project. Use a discount rate of 10%. Discuss the results by explaining what each of the methods mean and your decision on going forward with the project.

Year	Cash flow ($)
0	(850,000)
1	350,000
2	350,000
3	250,000
4	200,000
5	200,000

Answer 1

a. 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= -$850,000 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 discount rate of 10%.
• 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 $206,053.67.

Profitability Index= $206,053.67 + $850,000/ $850,000

                                   = 1,056,053.67/ $850,000

                                   = 1.2424.

Profitability index is a ratio of the discounted cash flow to the initial cash flow of the project. The project should be accepted according to the profitability index decision rule as it is more than 1.

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

• Press the CF button.
• CF0= -$850,000 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 discount rate of 10%.
• 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 $206,053.67.

Net present value helps to find out if the projected future cash flows cover the future cost of starting and running a business. It helps to understand how much an investment or project is worth. The project should be accepted according to the net present value decision rule since the project generates a positive net present value.

c. Internal rate of return can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= It is -$850,000. 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 IRR button and enter the interest rate to get the IRR of the project.

The IRR is 20.38%.

Internal rate of return is the rate of return that makes the net present value of all cash flows of a certain investment equal to zero. The project should be accepted according to the internal rate of return decision rule since the internal rate of return is higher than the cost of capital.

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