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 $2,750,000 in a project that is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$350,000
Year 2	$500,000
Year 3	$425,000
Year 4	$400,000

Purple Whale Foodstuffs 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):

A. 0.5055

B. 0.4573

C. 0.4814

D. 0.5536

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_________ the project.(Accept/reject)

By comparison, the NPV of this project is _________ . 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__________(=0/<0/>0); when it has a PI of 1.0, it will have an NPV ____________(=$0/<$0/>$0) .