Homework SourseProfitability index Given the discount rate and the future c
Profitability index. Given the discount rate and the future cash flow of each project listed in the following? table, use the PI to determine which projects the company should accept.
$1,200,000
What is the PI of project A and project B?
| Cash flow | Project A | Project B |
| Year 0 | -$2,100,000 | -$2,600,000 |
| Year 1 | $650,000 | $1,,300,000 |
| Year 2 | $750,000 | $1,200,000 |
| Year 3 | $850,000 | $1,100,000 |
| Year 4 | $950,000 | $1,000,000 |
| Year 5 | $1,050,000 | $900,000 |
| Discount rate | 4% | 15% |
Solution
Profitability index = Present value of future cash flows / initial investment
PV factor = 1/(1 + discount rate)^no. of years
Profitability index for project A
Sum of present value of cash flows = 3749151.51
Initial investment = 2100000
Profitability index = 3749151.51 / 2100000 = 1.785
Profitability index of project B
Sum of present value of cash flows = 3780287.35
Initial investment = 2600000
Profitability index = 3780287.35 / 2600000 = 1.454
As per the rule project with PI greater than 1 should be accept, since both the project has PI of greater than 1, we will choose the project with higher PI.
Project A has PI of 1.785 and project B has 1.454. So Project A has higher PI than project B.
Project A should be accepted.
| Year | Cash flow | Present Value Factor @4% | Present value of cash flow |
| 1 | 650000 | 0.962 | 625000 |
| 2 | 750000 | 0.925 | 693417.16 |
| 3 | 850000 | 0.889 | 755646.90 |
| 4 | 950000 | 0.855 | 812063.98 |
| 5 | 1050000 | 0.822 | 863023.46 |
