Question

(2 of 10) What is the profitability index for this proposed project if the required rate of return is 13%? Year Cash Flows -1,000,000 300,000 400,000 300,000 700,000 NO 1.16 1.13 1.22 1.25 1.32

Answer 1

PROFITABILITY INDEX = 1.22

	Cash Flow	Present Value of 1 at 13%	Present Value
Year 1	$              3,00,000.00	0.8850	$              2,65,500.00
Year 2	$              4,00,000.00	0.7831	$              3,13,240.00
Year 3	$              3,00,000.00	0.6931	$              2,07,930.00
Year 4	$              7,00,000.00	0.6133	$              4,29,310.00
PRESENT VALUE OF FUTURE CASH INFLOW (A)			$            12,15,980.00
INITIAL INVESTMENT (B)			$            10,00,000.00
PROFITABILITY INDEX (A) ÷ (B)			1.22

• The profitability index is a ratio that expresses the relationship between the costs and benefits of a project.
• Profitability index = PV of future cash flows ÷ Initial investment
• Profitability index greater than 1: Project should be accepted (it indicates the present value of anticipated future cash inflows are more than the present value of cash outflows)
• Profitability index less than 1: Project should be rejected. (it indicates the present value of anticipated future cash inflows are less than the present value of cash outflows)
• Profitability index equal to 1: Project is indifferent. (it indicates the present value of anticipated future cash inflows equals the present value of cash outflows)
• In case of mutually exclusive projects, the project with the highest profitability index is accepted.