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Homework answers / question archive / Dizzyland Enterprises has been presented with an investment opportunity which will yield end -of-year cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10

Dizzyland Enterprises has been presented with an investment opportunity which will yield end -of-year cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10

Finance

Dizzyland Enterprises has been presented with an investment opportunity which will yield end -of-year cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10%. What is the profitability index for this investment?

   

0.87

   

1.85

   

0.21

   

1.34

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Given the following information,

Years Cashflows
1 30000
2 30000
3 30000
4 30000
5 35000
6 35000
7 35000
8 35000
9 35000
10 40000

Cost of capital = r = 10% = 0.10

We know that profitability index is given by the following formula,

Profitability index = Present value of future cashflows/Initial investment required

Where,

Present value of future cashflows = ∑ CFi/(1+r)^i

CFi = Cashflow in year i

Years(i) Cashflows(CFi) (1+r)^i = (1+0.1)^i Cashflows/(1+r)^i
1 30000 1.1000 27272.73
2 30000 1.2100 24793.39
3 30000 1.3310 22539.44
4 30000 1.4641 20490.40
5 35000 1.6105 21732.25
6 35000 1.7716 19756.59
7 35000 1.9487 17960.53
8 35000 2.1436 16327.76
9 35000 2.3579 14843.42
10 40000 2.5937 15421.73
    ∑ CFi/(1+r)^i = 201138.24

∑ CFi/(1+r)^i = 27272.73 + 24793.39 + 22539.44 + 20490.40 + 21732.25 + 19756.59 + 17960.53 + 16327.76 + 14843.42 + 15421.73

∑ CFi/(1+r)^i = 201138.24

Initial investment required = 150,000 (given)

Substituting these in the above equation, we get

Profitability index = 201138.24/150,000

Profitability index = 1.34

Therefore, the profitability index for this investment is 1.34