Question

please slove step by step

8. Calculating Profitability Index Suppose the following two independent investment opportunities are available to Fitz, Inc. The appropriate discount rate is 8.5 percent. Project Alpha Project Beta Year OHN -$2,700 1,500 1,300 1,100 -$4,100 900 2,600 3,200 a. Compute the profitability index for each of the two projects. b. Which project(s) should the company accept based on the profitability index rule?

Answer 1

a.Project Alpha

Profitability index is calculated using the below formula:

Profitability Index= NPV + Initial investment/ Initial investment

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

• Press the CF button.
• CF0= -$2,700. Indicate the initial cash flow by 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 8.5%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.  

Net present value at 8.5% discount rate is $647.98.

Profitability Index= $647.98 + $2,700/ $2,700

   = $3,347.98/ $2,700

= 1.24.

Project Beta

Profitability index is calculated using the below formula:

Profitability Index= NPV + Initial investment/ Initial investment

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

• Press the CF button.
• CF0= -$4,100. Indicate the initial cash flow by 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 8.5%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.  

Net present value at 8.5% discount rate is $1,443.38.

Profitability Index= $$1,443.38 + $4,100/ $4,100

= $5,543.38/  $4,100

= 1.35.

b.The company should accept project beta since it has the largest profitability index.

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