Question

# Profitability index Estimating the cash flow generated by \$1 invested in investment The profitability index (PI)...

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.

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