Question

Yokam Company is considering two alternative projects. Project 1 requires an initial investment of $520,000 and has a present value of cash flows of $1,300,000. Project 2 requires an initial investment of $5 million and has a present value of cash flows of $6 million.
Compute the profitability index for each project.
Based on the profitability index which project should the company prefer?

Answer 1

Answer:

1. 2.5; 1.2

2. Project A

Explanation:

Given that,

Project 1 requires:

Initial investment = $520,000

Present value of cash flows = $1,300,000

Project 2 requires:

Initial investment = $5,000,000

Present value of cash flows = $6,000,000

1.

Profitability index = Present Value of Cash inflows ÷ Investment

Project A = $1,300,000 ÷ $520,000

                = 2.5

Project B = $6,000,000 ÷ $5,000,000

               = 1.2

2. Project A will be preferred because it has a higher profitability index than project B.