Consider a project with the following cash flows: After-Tax After-Tax
Accounting Cash Flow
Year Profits from Operations
1 $799 $750
2 $150 $1,000
3 $200 $1,200
Initial outlay = $1,500
Terminal cash flow = 0
Compute the profitability index if the company's discount rate is 10%.
A) 15.8
B) 1.61
C) 1.81
D) 0.62

Question

Quizplus · Accepted Answer

To calculate the profitability index, we need to divide the present value of future cash flows by the initial outlay. 
First, we need to calculate the present value of future cash flows using a discount rate of 10%:

PV1 = $750 / (1 + 0.10)^1 = $681.82 
PV2 = $1,000 / (1 + 0.10)^2 = $826.45 
PV3 = $1,200 / (1 + 0.10)^3 = $993.77

Total PV of future cash flows = PV1 + PV2 + PV3 = $2,502.04

Now we can calculate the profitability index:

Profitability Index = Total PV of future cash flows / Initial outlay 
= $2,502.04 / $1,500 
= 1.67

Therefore, the correct answer is B) 1.61.

A profitability index greater than 1 means that the project's present value of future cash flows is greater than its initial outlay, indicating that the project is profitable. Therefore, the best choice is to undertake the project.

Consider a Project with the Following Cash Flows: After-Tax After-Tax