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Profitability Index

PROFITABILITY INDEX:
Another project under consideration by Clayton Systems is the upgrading of its data processing operations. To change its operation will require a $1,500,000 investment and the new equipment will have a useful life of five years. The firm currently contracts out almost all of its data processing needs to an outside firm. The investment in the equipment is expected to generate the following net cash flows:
Year Net cash flow
1 $350,000
2 350,000
3 350,000
4 400,000
5 450,000

If a firm requires a 10 percent rate of return on this type of investment, compute the project's profitability index.

MUTUALLY EXCLUSIVE INVESTMENTS HAVING UNEQUAL LIVES:
Palmer, Inc. is considering two mutually exclusive investments that would expand its capacity to produce golf clubs. The firm requires a 15 percent rate of return on its capital investments and has determined that the projects have the following net cash flow streams.
Year A B
0 -$120,000 -$120,000
1 25,000 37,000
2 25,000 37,000
3 25,000 37,000
4 25,000 37,000
5 25,000 37,000
6 25,000
7 25,000
8 25,000
9 25,000
10 25,000

Assuming that project B can be replaced in year five at its original cost and that the cash flows in years six through ten will be $37,000, which project should be chosen?

Solution Summary

Solution contains calculation of NPV and profitability index.

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