11. 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 projects cash inflows divided by the absolute value of its initial cash outflow. Consider this case:

Purple Whale Foodstuffs is considering investing $2,225,000 in a project that is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$325,000
Year 2	$400,000
Year 3	$425,000
Year 4	$400,000

Purple Whale Foodstuffs uses a WACC of 7% when evaluating proposed capital budgeting projects. Based on these cash flows, determine this projects PI (rounded to four decimal places):

A: 0.5866

B: 0.6746

C: 0.7039

D: 0.5573

Purple Whale Foodstuffss decision to accept or reject this project is independent of its decisions on other projects. Based on the projects PI, the firm should___________ {reject/accept} the project.

By comparison, the NPV of this project is _______________ {-919K, 919K, -873K} . On the basis of this evaluation criterion, Purple Whale Foodstuffs should_________________ {invest/not invest} in the project because the project________________ {will/will not} increase the firms value.

A project with a negative NPV will have a PI that is__________________ {greater/equal/less than} ; when it has a PI of 1.0, it will have an NPV __________{less than/equal to/greater than}