Dreamland company is considering investing in Project Cloud or Project Rainbow.

Question

Dreamland company is considering investing in Project Cloud or Project Rainbow. Project Cloud generates the following cash flows: year "zero" 391 dollars (outflow); year 1 - 239 dollars (inflow); year 2 = 341 dollars (inflow); year 3-343 dollars (inflow); year 4-176 dollars (inflow). Project Rainbow generates the following cash flows: year "zero"-230 dollars (outflow); year 1 = 120 dollars (inflow); year 2 = 100 dollars (inflow); year 3-200 dollars (inflow); year 4-120 dollars (inflow). The MARR is 12 %. Compute the Profitability Index of the BEST project. (note: round your answer to two decimal places, and do not include spaces, currency signs, plus or minus signs, or commas)

Explanation / Answer

Profitability index is calculated by present value of all future cash flows divided by initial investment

A project is acceptable only if its value if greater than 1 and the project with highest value is best

Present value = cash flow/(1+r)n, where n is number of years and r is required rate

r is MARR in this i.e. 12%

Project Cloud

CF0 = 391 (outflow),. it is initial investment

CF1 = 239

CF2 = 341

CF3 = 343

CF4 = 176

Present value of future cash flows = CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 + CF4/(1+r)4

Present value of future cash flows = 239/(1.12)1 + 341/(1.12)2 + 343/(1.12)3 + 176/(1.12)4 = 841.23

Profitability index = Present value of future cash flows / initial investment = 841.23/391 = 2.15

Project Rainbow

CF0 = 230 (outflow),. it is initial investment

CF1 = 120

CF2 = 100

CF3 = 200

CF4 = 120

Present value of future cash flows = CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 + CF4/(1+r)4

Present value of future cash flows = 120/(1.12)1 + 100/(1.12)2 + 200/(1.12)3 + 120/(1.12)4 = 405.48

Profitability index = Present value of future cash flows / initial investment = 405.48/230 = 1.76

profitanbility index of project cloud is higher so we will choose that

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