Question

yokam company is considering two alternative projects. project 1 requires an initial investment of $420,000 and has a present value of all its cash flows of $1,800,000. project 2 requires an initial investment of $5 million and has a present value of all its cash flows of $7 million. (a) compute the profitability index for each project. (b) based on the profitability index, which project should the company select?

Answer 1

Project A will be preferred as it has a profitability index of 4.29.

Define Profitability index.

The profitability index, also known as the profit investment ratio and value investment ratio, is the measure of how much money would be made or lost on an investment for a given project. Given that it allows for the calculation of value produced per investment, it is a useful tool for project rating.

The profitability index is a measure of a project's profitability that compares the initial investment made with the present value of expected future cash flows. A project is considered to be more beneficial and enticing the higher the profitability index.

Profitability index = PV of Cash inflows / Investment

Project A = 1,800,000 / 420,000 = 4.29

Project B = 7000000 / 5000000 = 1.4

Project A will be preferred.

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