Cleaners, Inc.is considering purchasing equipment costing $30,000 with a 6-year useful life.The equipment will provide cost savings of $7,300 and will be amortized using the straight-line method over its useful life with no salvage value.Cleaners, Inc.requires a 10% rate of return.What is the approximate profitability index associated with this equipment?

Question

Quizplus · Accepted Answer

To determine the profitability index, we need to calculate the present value of the expected cash flows and divide it by the initial investment:

PV of cash flows = $7,300 per year for 6 years discounted at 10%
= $7,300 / (1 + 0.1)^1 + $7,300 / (1 + 0.1)^2 + ... + $7,300 / (1 + 0.1)^6
= $7,300 * (1/1.1 + 1/1.21 + ... + 1/1.77156)
= $32,409.77

Profitability Index = PV of cash flows / Initial investment
= $32,409.77 / $30,000
= 1.08

Therefore, the closest approximation to the profitability index is 1.06, which is answer choice C. This indicates that the investment is expected to generate positive net present value and is a good investment for the company.