Question

5. Find out the profitability index (PI) of the following project assuming the required
rate of return is 8%. Will you accept the project? Why?
year    0 1    2 3 4    5
Cash Flow -$250,000 50,000 40,000 120,000 80,000 45,000
A. Accept the project because the PI is equal to 1.06, which is larger than 0.
B. Accept the project because the PI is equal to 0.98, which is larger than 0.
C. Reject the project because the PI is equal to 1.06, which is larger than 1.
D. Reject the project because the PI is equal to 0.98, which is lower than 1.
E. Accept the project because the PI is equal to 1.06, which is larger than 1.

Answer 1

Profitability Index = Present value of future cash flows / initial investment

Calculating the present value of future cash flows

Year	Discount Rate (A)	Amount (B)	Present Value (A*B)
0	1	- 250,000	-250,000
1	0.926	50,000	46,296
2	0.857	40,000	34,294
3	0.794	120,000	95,260
4	0.735	80,000	58,802
5	0.681	45,000	30,626

Present Value of future cash flows = 265,278

Initial Investment = 250,000

Profitability Index = 265278/250000 = 1.06

E. Accept the project because the PI is equal to 1.06, which is larger than 1