Question

**Profitability index**

Estimating the cash flow generated by $1 invested in investment

The profitability index (PI) is a capital budgeting tool that provides another way to compare a project’s benefits and costs. It is computed as a ratio of the discounted value of the net cash flows expected to be generated by a project over its life (the project’s expected benefits) to its net cost (NINV). A project’s PI value can be interpreted to indicate a project’s discounted return generated by each dollar of net investment required to generate those returns.

Consider the case of Fuzzy Badger Transport Company:

Fuzzy Badger Transport Company is considering investing $500,000 in a project that is expected to generate the following net cash flows:

Year |
Cash Flow |
---|---|

Year 1 | $350,000 |

Year 2 | $425,000 |

Year 3 | $425,000 |

Year 4 | $500,000 |

Fuzzy Badger uses a WACC of 10% when evaluating proposed capital budgeting projects. Based on these cash flows, determine this project’s PI (rounded to four decimal places).

2.3945

2.2614

2.7935

2.6605

Fuzzy Badger’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 the project.

By comparison, the net present value (NPV) of this project is . On the basis of this evaluation criterion, Fuzzy Badger should in the project because the project increase the firm’s value.

When a project has a PI greater than 1.00, it will exhibit an NPV ; when it has a PI of 1.00, it will have an NPV equal to $0. Projects with PIs 1.00 will exhibit negative NPVs.

Answer #1

Estimating the cash flow generated by $1 invested in investment
The profitability index (PI)is a capital budgeting tool that
provides another way to compare a project’s benefits and costs. It
is computed as a ratio of the discounted value of the net cash
flows expected to be generated by a project over its life (the
project’s expected benefits) to its net cost (NINV). A project’s PI
value can be interpreted to indicate a project’s discounted return
generated by each dollar...

9. 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 Inc. is considering investing $2,225,000
in a project that is expected to generate the following net cash
flows:
Year
Cash Flow
Year 1
$350,000
Year 2
$400,000
Year 3...

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...

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:
Year
Cash Flow
Year 1
$325,000
Year 2
$425,000
Year 3
$450,000
Year 4
$425,000
Free Spirit Industries Inc. uses a WACC of 7% when...

Evaluating cash flows with the NPV method
The net present value (NPV) rule is considered one of the most
common and preferred criteria that generally lead to good
investment decisions.
Consider this case:
Suppose Fuzzy Button Clothing Company is evaluating a proposed
capital budgeting project (project Alpha) that will require an
initial investment of $450,000. The project is expected to generate
the following net cash flows:
Year
Cash Flow
Year 1
$325,000
Year 2
$475,000
Year 3
$450,000
Year 4...

The profitability index (PI) of a project is 1.1, and the
initial investment (cost) is $10,000
. What do you know about the project's net present value (NPV)
and its internal rate of return (IRR)?

1. Net present value (NPV)
Evaluating cash flows with the NPV method
The net present value (NPV) rule is considered one of the most
common and preferred criteria that generally lead to good
investment decisions.
Consider this case:
Suppose Happy Dog Soap Company is evaluating a proposed capital
budgeting project (project Alpha) that will require an initial
investment of $450,000. The project is expected to generate the
following net cash flows:
Year
Cash Flow
Year 1
$375,000
Year 2
$425,000...

You are evaluating a capital budgeting project that costs
$25,000 and is expected to generate cash flows equal to $10,000 per
year for four years. The required rate of return is 10 percent.
Compute the project’s (a) net present value, (b) profitability
index, and (c) internal rate of return. (d) Should the project be
purchased?

1. NPV (Net Present Value) versus PI
(Profitability Index)
Consider the following two mutually exclusive projects
available to Global Investments, Inc.:
Projects
C0
C1
C2
PI
NPV
A
-$1000
$1000
$500
1.32
$322
B
-500
500
400
1.57
285
The appropriate discount rate for the projects is 10%.
Global Investments chose to undertake project A. At a luncheon for
shareholders, the manager of a pension fund that owns a substantial
amount of the firm’s stock asks you why the...

The net present value (NPV) and internal rate of return (IRR)
methods of investment analysis are interrelated and are sometimes
used together to make capital budgeting decisions.
Consider the case of Blue Hamster Manufacturing Inc.:
Last Tuesday, Blue Hamster Manufacturing Inc. lost a portion of
its planning and financial data when both its main and its backup
servers crashed. The company’s CFO remembers that the internal rate
of return (IRR) of Project Delta is 11.3%, but he can’t recall how...

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