Question

yokam company is considering two alternative projects. project 1 requires an initial investment of $440,000 and has a present value of all its cash flows of $2,400,000. project 2 requires an initial investment of $5 million and has a present value of all its cash flows of $6 million. (a) compute the profitability index for each project.(b) based on the profitability index, which project should the company select?

Answer 1

To calculate the profitability index, divide the present value of future cash flows by the initial investment. Project 1 has a profitability index of 5.45, and Project 2 has an index of 1.2. Therefore, Project 1 is the better choice based on this criterion.

Step-by-step explanation:

The profitability index (PI) is a calculation that determines the relative profitability of a project. It is computed by dividing the present value of future cash flows by the initial investment required for the project. To compute the profitability index for the given projects:

• Project 1: PI = $2,400,000 / $440,000 = 5.45
• Project 2: PI = $6,000,000 / $5,000,000 = 1.2

The profitability index for Project 1 is 5.45, and for Project 2 it is 1.2. The company should select the project with the higher profitability index, which is Project 1.