Your firm is considering an investment that will cost 920000

Your firm is considering an investment that will cost $920,000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%, what is the investment\'s profitability index? a. 1.26 b. 1.69 c. 1.21 d. 1.43

Solution

Year 1 cash flow = $450,000

Year 2 cash flow = $270,000

Year 3 cash flow = $270,000

Year 4 cash flow = $270,000

Year 5 cash flow = $200,000

Discount rate = 11.25% = 0.1125

Present value of future cash flows = $450,000/1.1125 + $270,000/1.1125² + $270,000/1.1125³ + $270,000/1.1125⁴ + $200,000/1.1125⁵ = $1,112,369.06

Initial investment = $920,000

Profitability index = Present value of future cash flows/Initial investment

Profitability index = $1,112,369.06/$920,000 = 1.209

Hence, correct answer is c.1.21