Profitability Index and NPV Problems
1. Calculate the Profitability index of a capital project. The initial investment is $250,000 for the purchase of some new radiology equipment. The new equipment will save the organization $15,000 a year for the next 10 years. The project discount rate is 12%.
• Determine the present value of the operating savings:
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Present value of saving = savings per year X discounted rate
• Determine the net present value (NPV)
Pay close attention here, this is where basic mathematical functions need to follow financial accounting theory. Hence, if we have a positive value for the present value of savings, we cannot have a negative NPV. We started with an initial investment amount, so start there are subtract your net present value from that amount to determine your NPV.
NPV=present value of savings – initial investment
• Determine the profitability index
Profitability Index = NPV/initial investment