9. 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 projects 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 projects expected benefits) to its net cost (NINV). A projects PI value can be interpreted to indicate a projects discounted return generated by each dollar of net investment required to generate those returns.

Consider the case of Purple Whale Foodstuffs Inc.:

Purple Whale Foodstuffs Inc. is considering investing $600,000 in a project that is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$275,000
Year 2	$400,000
Year 3	$425,000
Year 4	$450,000

1. Purple Whale uses a WACC of 10% when evaluating proposed capital budgeting projects. Based on these cash flows, determine this projects PI (rounded to four decimal places).

- 1.7103

- 2.2133

- 2.0121

- 2.1127

2. Purple Whales decision to accept or reject this project is independent of its decisions on other projects. Based on the projects PI, the firm should (ACCEPT OR REJECT) the project.

By comparison, the net present value (NPV) of this project is ($607,243, 485,794, 667,967, -7,243, 576,881, 728,692) . On the basis of this evaluation criterion, Purple Whale should (NOT INVEST OR INVEST) in the project because the project (WILL OR WILL NOT) increase the firms value.

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

The answer options for the word problem are in bold font. Thank you.