The profitability index (PI) is a capital budgeting tool that is defined as the present value of a project’s cash inflows divided by the absolute value of its initial cash outflow. Consider this case:
Free Spirit Industries Inc. is considering investing $2,500,000 in a project that is expected to generate the following net cash flows:
Free Spirit Industries Inc. uses a WACC of 7% when evaluating proposed capital budgeting projects. Based on these cash flows, determine this project’s PI (rounded to four decimal places):
Free Spirit Industries Inc.’s decision to accept or reject this project is independent of its decisions on other projects. Based on the project’s PI, the firm should (accept or reject?) the project.
By comparison, the NPV of this project is (-1,133,486; -1,360,183; or -906,789?) . On the basis of this evaluation criterion, Free Spirit Industries Inc. should (invest or not invest?) in the project because the project (will or will not?) increase the firm’s value.
A project with a negative NPV will have a PI that is (greater than 1.0; equal to 1.0; or less than 1.0?) ; when it has a PI of 1.0, it will have an NPV (equal to 0, less than 0, greater than 0?) .
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