A project will cost $20,000 and is expected to produce cash flows of $10,000, $8,000, and $5,000 at the end of each of the first three years, respectively. If the cost of capital is 7%, what is the
Project's profitability index? Round your answer to the nearest hundredth.
A)1.02
B)0.02
C)0.98
D)1.15

Question

Quizplus · Accepted Answer

The profitability index (PI) is calculated by dividing the present value (PV) of future cash flows by the initial investment. The formula for the present value of each cash flow is PV = Cash Flow / (1 + r)^n, where r is the discount rate (cost of capital) and n is the year of the cash flow. Year 1: PV = $10,000 / (1 + 0.07)^1 = $9,345.79Year 2: PV = $8,000 / (1 + 0.07)^2 = $7,002.80Year 3: PV = $5,000 / (1 + 0.07)^3 = $4,176.73Total PV of cash flows = $9,345.79 + $7,002.80 + $4,176.73 = $20,525.32Profitability Index = Total PV of cash flows / Initial Investment = $20,525.32 / $20,000 = 1.026Rounded to the nearest hundredth, the profitability index is 1.02.

A Project Will Cost $20,000 and Is Expected to Produce