An investment project requires a net investment of $100,000 and is expected to generate annual net cash inflows of $25,000 for 6 years. The firm's cost of capital is 12%. Determine the profitability index for this project.
A) 1.50
B) 1.028
C) 0.028
D) 0.972

Question

Quizplus · Accepted Answer

The profitability index (PI) is calculated by dividing the present value of future cash flows by the initial investment.

PV of cash inflows = $25,000 * [(1 - 1/(1+12%)^6)/0.12] = $109,742.77

PI = PV of cash inflows / Net investment
   = $109,742.77 / $100,000
   = 1.028

Therefore, the answer is B, with a profitability index of 1.028. This means that for every dollar invested, the project will return $1.028 in present value of future cash inflows. This is greater than 1, indicating that the project is expected to generate positive net present value and is therefore acceptable.

An Investment Project Requires a Net Investment of $100,000 and Is