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:

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