Question

Refer to two projects with the following cash flows:   

Year Project A Project B

0 -$120 -$120

1 50 60

2 50 60

3 50 60

4 50  

If the opportunity cost of capital is 13%, what is the profitability index for each project? (Round to 4 decimal places.)

Does the profitability index rank the projects A and B correctly?

Answer 1

Profitability Index (PI) for Project-A

Year	Annual cash inflow ($)	Present Value factor at 13.00%	Present Value of Annual cash inflow ($)
1	50.00	0.88496	44.25
2	50.00	0.78315	39.16
3	50.00	0.69305	34.65
4	50.00	0.61332	30.67
TOTAL			148.72

The profitability Index (PI) for the Project-A = Present value of annual cash inflows / Initial Investment

= $148.72 / $120

= 1.2394

Profitability Index (PI) for Project-B

Year	Annual cash inflow ($)	Present Value factor at 13.00%	Present Value of Annual cash inflow ($)
1	60.00	0.88496	53.10
2	60.00	0.78315	46.99
3	60.00	0.69305	41.58
TOTAL			141.67

The profitability Index (PI) for the Project-B = Present value of annual cash inflows / Initial Investment

= $141.67 / $120

= 1.1806

NOTE

The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)ⁿ], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.