Question

**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 | $425,000 |

Year 4 | $475,000 |

Purple Whale Foodstuffs 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):

0.7162

0.6228

0.5605

0.7474

Purple Whale Foodstuffs 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 ???? the project.

By comparison, the NPV of this project is ???? . On the basis of this evaluation criterion, Purple Whale Foodstuffs Inc. should ???? in the project because the project ???? increase the firm’s value.

A project with a negative NPV will have a PI that is ???? ; when it has a PI of 1.0, it will have an NPV ????? .

Answer #1

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...

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...

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...

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...

Based on the profitability index rule, should a project with the
following cash flows be accepted if the discount rate is 15
percent? Why or why not? (i.e. Calculate the profitability index
(PI) and explain why the project should or should not be
accepted.)
Year: 0,1,2,3
Cash Flow: -32100, 11,800, 0, 22,600

Profitability index. Given the discount rate and the future cash
flow of each project listed in the following table, use the PI to
determine which projects the company should accept.
What is the PI of project A?
What is the PI of Project B?
Cash Flow
Project A
Project B
Year 0
−$2,000,000
−$2,300,000
Year 1
$600,000
$1,150,000
Year 2
$700,000
$1,050,000
Year 3
$800,000
$950,000
Year 4
$900,000
$850,000
Year 5
$1,000,000
$750,000
Discount rate
5%
16%

Cold Goose Metal Works Inc. is analyzing a project that requires
an initial investment of $2,225,000. The project’s expected cash
flows are:
Year
Cash Flow
Year
1
$350,000
Year
2
–200,000
Year
3
400,000
Year
4
400,000
Cold Goose Metal Works Inc.’s WACC is 9%, and the project has
the same risk as the firm’s average project. Calculate this
project’s modified internal rate of return (MIRR).
18.18%
20.46%
19.32%
-14.33%
If Cold Goose Metal Works Inc.’s managers select projects based...

Suppose Acme Manufacturing Corporation’s CFO is evaluating a
project with the following cash inflows. She does not know the
project’s initial cost; however, she does know that the project’s
regular payback period is 2.5 years.
Year
Cash Flow
Year 1
$350,000
Year 2
$425,000
Year 3
$475,000
Year 4
$425,000
If the project’s weighted average cost of capital (WACC) is 7%,
what is its NPV?
$397,786
$437,565
$417,675
$457,454
Which of the following statements indicate a disadvantage of
using the...

Telesis Corp is considering a project that has the
following cash flows:
Year
Cash Flow
0
-$1,000
1
400
2
300
3
500
4
400
The company’s weighted average cost of capital (WACC) is
10%. What are the project’s payback period (Payback), internal rate
of return (IRR), net present value (NPV), and profitability index
(PI)?
A.
Payback = 3.5, IRR = 10.22%, NPV = $1260, PI=1.26
B.
Payback = 2.6, IRR = 21.22%, NPV = $349, PI=1.35
C.
Payback =...

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 Hungry Whale Electronics is evaluating a proposed
capital budgeting project (project Alpha) that will require an
initial investment of $400,000. The project is expected to generate
the following net cash flows:
Year
Cash Flow
Year 1
$325,000
Year 2
$400,000
Year 3...

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