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

Quizplus · Accepted Answer

To calculate the profitability index, we need to divide the present value of the expected cash flows by the initial investment.

Using a financial calculator or spreadsheet, we can calculate the present value of the cash flows as follows:

Year 1: $60,000 / (1 + 0.15)^1 = $52,173
Year 2: $70,000 / (1 + 0.15)^2 = $54,791
Year 3: $80,000 / (1 + 0.15)^3 = $48,729
Year 4: $90,000 / (1 + 0.15)^4 = $42,962
Year 5: $110,000 / (1 + 0.15)^5 = $56,580

Total present value of cash flows = $255,235

The profitability index is then calculated as follows:

Profitability index = Total present value of cash flows / Initial investment
Profitability index = $255,235 / $250,000
Profitability index = 1.02

Therefore, the project's profitability index is 1.06. This means that the project is expected to generate $1.06 in present value of cash flows for every $1 invested, which is higher than the required return of 15%. The project should be accepted.

Floyd Clymer Is the CFO of Bonavista Mustang, a Manufacturer