5. 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 Blue Moose Home Builders:

Blue Moose Home Builders is considering investing $550,000 in a project that is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$325,000
Year 2	$450,000
Year 3	$475,000
Year 4	$425,000

Blue Moose uses a WACC of 9% when evaluating proposed capital budgeting projects. Based on these cash flows, determine this projects PI (rounded to four decimal places).

2.2006

2.0783

2.4451

1.9561

Blue Mooses 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.

By comparison, the net present value (NPV) of this project is . On the basis of this evaluation criterion, Blue Moose should in the project because the project increase the firms 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.