Suppose your firm is considering investing in a project with the cash flows show
ID: 2821714 • Letter: S
Question
Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 7 percent, and that the maximum allowable payback and discounted payback statistics for the project are 3.5 and 4.5 years, respectively.
Use the PI decision rule to evaluate this project. (Do not round intermediate calculations and round your final answer to 2 decimal places.)
Time: 0 1 2 3 4 5 6 Cash flow: –$5,100 $1,240 $2,440 $1,640 $1,640 $1,440 $1,240Explanation / Answer
Cash Flows:
Year 0 = -$5,100
Year 1 = $1,240
Year 2 = $2,440
Year 3 = $1,640
Year 4 = $1,640
Year 5 = $1,440
Year 6 = $1,240
Rate of Return = 7%
Present Value of Cash Inflows = $1,240/1.07 + $2,440/1.07^2 + $1,640/1.07^3 + $1,640/1.07^4 + $1,440/1.07^5 + $1,240/1.07^6
Present Value of Cash Inflows = $7,732.91
Profitability Index = Present Value of Cash Inflows / Initial Cash Outflow
Profitability Index = $7,732.91 / $5,100
Profitability Index = 1.52
According to PI decision rule, the project should be accepted if PI is greater than 1.
So, we should accept this project.
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