Question

Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 13 percent, and that the maximum allowable payback and discounted payback statistics for your company are 2.5 and 3.0 years, respectively. Time: 0 1 2 3 4 5 Cash flow: –$367,000 $64,800 $83,000 $140,000 $121,000 $80,200 Use the PI decision rule to evaluate this project. (Do not round intermediate calculations and round your final answer to 2 decimal places.) Should it be accepted or rejected? accepted rejected.

Answer 1

Profitability index is calculated using the below formula:

Profitability Index= NPV + Initial investment/ Initial investment

Net present value is solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$367,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for all the years should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow, press the NPV button and enter the required rate of return of 13%.
• Press the down arrow and CPT buttons to get the net present value.

Net Present value of cash flows at 13% required rate of return is -$29,885.76.

Profitability Index= -$29,885.76 + $367,000/ $367,000

                      = $337,114.24/ $367,000

                      = 0.9186.

The project should be rejected since the profitability index of the project is less than 1.

In case of any query, kindly comment on the solution.