Question

A given investment project will cost RM400,000. Incremental annual cash flows after taxes are expected to be RM80,000 per year for the life of the investment, which is 5 years. There will be no salvage value at the end of the 5 years. The required rate of return is 14%. On the basis of the profitability index method, should the investment be accepted?

Answer 1

Based on the profitability index method, the investment should not be accepted.

It does not produce enough cash flows to justify the investment.

Step-by-step explanation:

The profitability index method measures the present value of benefits for by dividing the present value of benefits by the present of initial investments.

The present value of initial investment in this project remains RM400,000. The present value of incremental annual cash flows of RM80,000 after taxes for 5 years will be equal to:

RM80,000 * 3.668 = RM293,440

Then the next step is to divide the present value of benefits by the initial investment as follows:

RM293,440/RM400,000 = 0.7336 = 73.36%

The implication is that the present value of the benefits is less than the initial investment costs. The project should then be rejected.