Hollister, Inc. is currently considering an eight-year project that ha

Hollister, Inc. is currently considering an eight-year project that has an initial outlay or cost of $120,000. The future cash inflows from its project for years 1 through 8 are the same at $30,000. Hollister has a discount rate of 11%.

Because of capital rationing (shortage of funds for financing), Hollister wants to compute the profitability index (PI) for each project. What is the PI for Hollister’s current project?
A) About 1.29
B) About 1.31
C) About 1.33
D) About 1.39

ANSWER

Answer: A
Explanation: A) The PI is (NPV plus the absolute value of the costs) divided by the absolute value of the costs (or the present value of all future cash flows divided by the cost). The future after-tax cash inflows are an annuity. Thus, we can use:
NPV = -CF0 + . Inserting the given values gives:
NPV = -$120,000 + = -$120,000 + ($30,000 × 5.146123)
= -$120,000 + $154,383.68 = $34,383.68. We can now compute the PI.

We have: PI = = = 1.2865 or about 1.29.