9. 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 $500,000 in a project that is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$275,000
Year 2	$400,000
Year 3	$475,000
Year 4	$475,000

Blue Moose 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).

2.0190

2.5238

2.7762

2.6500

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 ____(accept or reject)___ the project.

By comparison, the net present value (NPV) of this project is___________ . On the basis of this evaluation criterion, Blue Moose should _____(invest or not invest)_________ in the project because the project _____(will or will not)_____ increase the firms value.

When a project has a PI greater than 1.00, it will exhibit an NPV ____(greater than $0, less than $0 or equal to $0)___ ; when it has a PI of 1.00, it will have an NPV equal to $0. Projects with PIs ____(equal to, less than or greater than)_____ 1.00 will exhibit negative NPVs.