Question

11. Profitability index Estimating the cash flow generated by $1 invested in a project 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: Purple Whale Foodstuffs is considering investing $3,225,000 in a project that is expected to generate the following net cash flows: Year Cash Flow Year 1 $375,000 Year 2 $475,000 Year 3 $400,000 Year 4 $475,000 Purple Whale Foodstuffs uses a WACC of 8% when evaluating proposed capital budgeting projects.

Based on these cash flows, determine this project’s PI (rounded to four decimal places): 0.5288 0.5068 0.4848 0.4407

Purple Whale Foodstuffs’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 _____________. On the basis of this evaluation criterion, Purple Whale Foodstuffs 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 ____________( less than 1.0, greater than 1.0, or equal to 1.0); when it has a PI of 1.0, it will have an NPV _________(equal to 0, less than 0, or greater than 0).

Answer 1