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 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 $1$ $$275,000$

Year $2$ $$425,000$

Year $3$ $$400,000$

Year $4$ $$425,000$

Free Spirit uses a WACC of $7\%$ when evaluating proposed capital budgeting projects. Based on these cash flows, determine this project$$s PI $($rounded to four decimal places$).$

$3\mathrm{.}1264$

$2\mathrm{.}7001$

$2\mathrm{.}5580$

$2\mathrm{.}8422$

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 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 $1\mathrm{.}00,$ it will exhibit an NPV ; when it has a PI of $1\mathrm{.}00,$ it will have an NPV equal to $$0.$ Projects with PIs $1\mathrm{.}00$ will exhibit negative NPVs$.$