Question

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 Blue Moose Home Builders:

Blue Moose Home Builders is considering investing $400,000 in a project that is expected to generate the following net cash flows:

Year Cash Flow

Year 1 $300,000

Year 2 $450,000

Year 3 $450,000

Year 4 $400,000

Blue Mooseuses 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): a.2.7939

b.3.6157

c,3.1226

d.3.2870

Blue Moose’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/reject) the project.

By comparison, the net present value (NPV) of this project is__________ ($731,854,$914,817, -$514,817, $1,006,299,$1,097,780,$869,076). On the basis of this evaluation criterion, Blue Moose should _____________(invest/not invest) in the project because the project _____________(will/will not) increase the firm’s value.

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

Answer 1