Zellars,Inc.is considering two mutually exclusive projects,A and B.Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two.Project B costs $120,000 and is expected to generate $64,000 in year one,$67,000 in year two,$56,000 in year three,and $45,000 in year four.Zellars,Inc.'s required rate of return for these projects is 10%.The profitability index for Project A is
A) 1.27.
B) 1.22.
C) 1.17.
D) 1.12.

Question

Quizplus · Accepted Answer

To calculate the profitability index for Project A, we first need to calculate its net present value (NPV) using the formula:

NPV = (CF1 / (1 + r)^1) + (CF2 / (1 + r)^2)

Where CF1 and CF2 are the cash flows in year one and year two, respectively, r is the discount rate (which is 10% in this case), and ^ indicates exponentiation.

Plugging in the values, we get:

NPV = (65,000 / 1.1) + (75,000 / 1.1^2) = 52,734.56

Next, we divide the NPV by the initial cost of the project ($95,000) to get the profitability index:

Profitability index = NPV / Initial Cost = 52,734.56 / 95,000 = 1.27

Therefore, the profitability index for Project A is 1.27. Since Project B has a lower profitability index (computed similarly), the best choice would be to choose Project A.