Floyd Clymer is the CFO of Bonavista Mustang, a manufacturer of parts for classic automobiles. Floyd is considering the purchase of a two-ton press which will allow the firm to stamp out auto fenders. The equipment costs $250,000. The project is expected to produce after-tax cash flows of $60,000 the first year, and increase by $10,000 annually; the after-tax cash flow in year 5 will reach $100,000. Liquidation of the equipment will net the firm $10,000 in cash at the end of five years, making the total cash flow in year five $110,000.

Assuming a required return is 15%, what is the project's profitability index?

Question

Assuming a required return is 15%, what is the project's profitability index?

Quizplus · Accepted Answer

The profitability index (PI) is calculated by dividing the present value of future cash flows by the initial investment. The cash flows are $60,000, $70,000, $80,000, $90,000, and $110,000 for years 1 to 5, respectively. Discount these cash flows at 15% and sum them up. Then, divide by the initial investment of $250,000. The PI is approximately 1.06.

Floyd Clymer Is the CFO of Bonavista Mustang, a Manufacturer