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Which of the following methods will provide a correct analysis for capital budgeting purposes? discounting real cash flows wi
A projects Profitability Index is.85 and its net present value of $250,000. Given this information, determine the cost of th
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Answer #1

a) The first option is correct.

We should use real rates for discounting real cash flows and nominal rates for discounting nominal cash flow.

Hence option b, c, and d are incorrect.

b) In this question, there is some error:

NPV is $250000 (positive), which shows that this project is generating value and if this project is generating value its profitability index should be greater than 1 which not the case.

In order to solve this problem, I am considering that the present value of future cash flow (in spite of NPV) is $250,000.

Profitability Index = (NPV + Initial Investment ) / Initial Investment = PV of future cash flow/ Initial Investment

0.85 = $250000 / Initial Investment

Initial Investment or Cost of the project = $250000/ 0.85 = $294117.6471 = $294118 (approx.) Answer

Hence fourth option is correct.

Please let me know in case you have any queries.

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