Question

You are asked to evaluate the following two projects for the Norton corporation. Use a discount rate of 10 percent. Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods. Project X (Videotapes of the Weather Report) ($ 24,000 Investment) Year Cash Flow $12,000 10,000 11,000 10,600 Project Y (Slow-Motion Replays of Commercials) ($44,000 Investment) Year Cash Flow $ 22,000 15,000 16,000 18,000 w a. Calculate the profitability index for project X. (Do not round intermediate calculations and round your answer to 2 decimal places.) Profitability index | b. Calculate the profitability index for project Y. (Do not round intermediate calculations and round your answer to 2 decimal places.) Profitability index

Answer 1

1. Profitability Index for Project X

Profitability Index = Present Value of Future Cash Flows ÷ Initial Investment

Initial Investment = $24,000

Present Value of Future Cash Flows

Year	Cash Flows In $	Present value factor @ 10%	Present Value
(I)	(II)	(III)	(II) * (III)
1	$12,000	0.9091	$10,909.20
2	$10,000	0.8264	$8,264.00
3	$11,000	0.7513	$8,264.30
4	$10,600	0.6830	$7,239.80
Present Value of the future Cash inflows			$34,677.30

Profitability Index = $34,677.30 ÷ $24,000

                                    =1.44

2. Profitability Index for Project Y

Profitability Index = Present Value of Future Cash Flows ÷ Initial Investment

Initial Investment = $44,000

Present Value of Future Cash Flows

Year	Cash Flows In $	Present value factor @ 10%	Present Value
(I)	(II)	(III)	(II) * (III)
1	$22,000	0.9091	$20,000.20
2	$15,000	0.8264	$12,396.00
3	$16,000	0.7513	$12,020.80
4	$18,000	0.6830	$12,294.00
Present Value of the future Cash inflows			$56,711.00

Profitability Index = $56,711 ÷ $44,000

                                    =1.29

3. Which Project to be selected

• Project A

Decision Rule

IF	Decision
Profitability Index > 1	Accept the Project
Profitability Index < 1	Reject the project

In the given case both project is having Profitability Index > 1, which mean both project can be accepted. Since project A Profitability Index higher than project B, so we prefer project A.

Profitability Index is higher the better.

Note:

Calculation of Present value Factor

Discount Factor = 1/ (1+R) ^N

R = Discount Rate (i.e. = 10%)

N = No of years

E.g. for year 2 Discount Factor = 1/ (1.10)²

                                                                ⁼ 1/ (1.10) (1.10)

                                                = 0.8264