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 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 return generated by each dollar of net investment required to generate those returns.

Consider the case of Free Spirit Industries Inc.: Free Spirit Industries Inc. is considering investing $450,000 in a project that is expected to generate the following net cash flows: Year Cash Flow Year 1 $350,000 Year 2 $450,000 Year 3 $500,000 Year 4 $450,000

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

3.1216 2.6534 2.8094 3.2777

Free Spirit's decision to accept or reject this project is independent of its decisions on other projects. Based on the project's PI, the firm should (accept/reject ) the project.

By comparison, the net present value (NPV) of this project is_____________ . On the basis of this evaluation criterion, Free Spirit should__________ in the project because the project________________ increase the firm's 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.