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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 Purple Whale Foodstuffs Inc.: Purple Whale Foodstuffs Inc. is considering investing $550,000 in a project that is expected to generate the following net cash flows: Year Cash Flow Purple Whaleuses 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): Year 1 $375,000 Year 2 $400,000 Year 3 $500,000 Year 4 $450,000 O 2.1110 O 2.7706 0 2.5068 0 2.6387 Purple Whale'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, Purple Whale 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. 3. Net present value method Aa Aa Consider the case of Underwood Manufacturing: Underwood Manufacturing is evaluating a proposed capital budgeting project that will require an initial investment of $120,000. The project is expected to generate the following net cash flows: Year Cash Flow Year 1 $37,600 $50,500 Year 2 Year 3 $45,000 $41,900 Year 4 Assume the desired rate of return on a project of this type is 10%. What is the net present value of this project? 0 - $4,415.10 O $18,344.79 - $7,244.50 O $23,914.50 Suppose Underwood Manufacturing has enough capital to fund the project, and the project is not competing for funding with other projects. Should Underwood Manufacturing accept or reject this project? O Accept the project O Reject the project