Need assistance with another formula. Please provide me a formula to
calculate the profibility index for the following project, assuming
there is a 22 percent opportunity cost of capital.

Project A    

Cash flow       cash flow year one         cash flow year two
-2,100                +2,ooo                    +1,200


Any help would be great. Thank you.

Hi!!

By definition the profitability index of a project is the ratio
between the present value of the future cash flows and the initial
investment required for that project. Also called the benefit-cost
ratio:

PI = PV / I 

"Profitability Index":
http://www.investopedia.com/terms/p/profitability.asp


Recall the PV formula:

         CF1           CF2        
PV  = ---------  +  ----------  
      (1 + r)^1     (1 + r)^2	 

Then:

            CF1           CF2       
PI  =  [ ---------  +  ---------- ] / I
         (1 + r)^1     (1 + r)^2    

For this problem we have:    
r = 0.22
CF1 = $2,000
CF2 = $1,200
I = $2,100

Pluging the above values in the formula you will get a profitability
index equal to 1.1646


I hope that this helps you. Feel free to request for a clarification
if you need it.

Regards,
livioflores-ga

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Request for Answer Clarification by baseball2-ga on 24 Jul 2005 11:24 PDT

Hi...I thought I got it but I must be plugging something in wrong.
Based on what you indicated below to figure the pricing index I
plugged in the following into my calculator

(2,000 % (1 + 0.22)^1 + (1,200 % (1 + 0.22)^2 = 2783.95

I then divided 2783.95 by 2,100 and I am coming up with 1.33 not 1.1646

HELP!

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Clarification of Answer by livioflores-ga on 24 Jul 2005 15:52 PDT

Hi!!

I do not know where your error is, but note that you are missing a
parenthesis in your expression, well actually you are using more than
the needed ones. Use the following:
2,000 % (1 + 0.22)^1 + 1,200 % (1 + 0.22)^2 =
instead of:
(2,000 % (1 + 0.22)^1 + (1,200 % (1 + 0.22)^2 =

You can use also:
(2,000 % (1 + 0.22)^1 + 1,200 % (1 + 0.22)^2) =


By the way here are my own calculations:

2,000/(1+0.22)^1 = 2,000/1.22 = 1,639.34

1,200/(1+0.22)^2 = 1,200/1.4884 = 806.23

then:
PV = 2,000/(1+0.22)^1 + 1,200/(1+0.22)^2 = 2,445.57

Then:
PI = 2,445.57 / 2,100 = 1.1646


Hope this helps you.

Regards,
livioflores-ga