Profitability index

Estimating the cash flow generated by $$1$ invested in investment

The prafitability 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 retum generated by each dollar of net investment required to generate those

returns.

Consider the case of Fuzzy Badger Transport Company:

Fuzzy Badger Transport Company is considering investing $$550,000$ in a project that is expected to generate the following net cash

flows:

Fuzzy Badger uses a WACC of $9\%$ when evaluating proposed capital budgeting projects. Based on these cash nows, determine this project's PI

$($rounded to four decimal places$).$

$1\mathrm{.}8077$

$2\mathrm{.}2596$

$1\mathrm{.}9207$

$2\mathrm{.}1466$

Fuzzy Badger's decision to accept or reject this project is inde

the project.

By comparison, the net present value $($NPV$)$ of this project is

$.$ On the basis of this evaluation criterion, Fuzzy Badger should

in the project because the project

will

increase the firm's value.

When a project has a PI greater than $1\mathrm{.}00,$ it will exhibit an NPV greater than $$0$grad; when it has a PI of $1\mathrm{.}00,$ it will have an NPV equal to $$0.$

Projects with PIs

$\_1\mathrm{.}00$ will exhibit negative NPVs$.$