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9. Profitability index Estimating the cash flow generated by $1 invested in a project The profitability...

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 ????? .

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