WKW, Inc. is analyzing a project that requires an initial investment of $10,000, followed by cash inflows of $1,000 in Year 1, $4,000 in Year 2, and $15,000 in Year 3. The cost of capital is 10%. What is the profitability index of the project?
A) 1.04
B) 1.55
C) 1.78
D) 1.97

Question

Quizplus · Accepted Answer

To calculate the profitability index, we divide the present value of the cash inflows by the initial investment.

PV of Year 1 cash inflow = $1,000 / (1 + 0.1) = $909.09
PV of Year 2 cash inflow = $4,000 / (1 + 0.1)^2 = $3,305.79
PV of Year 3 cash inflow = $15,000 / (1 + 0.1)^3 = $11,396.02

Total PV of cash inflows = $909.09 + $3,305.79 + $11,396.02 = $15,610.90

Profitability index = Total PV of cash inflows / Initial investment
= $15,610.90 / $10,000
= 1.56

Therefore, the profitability index of the project is 1.56, which means that for every dollar invested, the project is expected to return $1.56. The best choice would be B, as it has the highest profitability index.

WKW, Inc Is Analyzing a Project That Requires an Initial Investment