Profitability index Estimating the cash flow generated by $1 invested in a project The profitability index...

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 project’s cash inflows divided by the absolute value of its initial cash outflow. Consider this case:

Happy Dog Soap Company is considering investing $2,225,000 in a project that is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$275,000
Year 2	$500,000
Year 3	$450,000
Year 4	$450,000

Happy Dog Soap Company uses a WACC of 10% when evaluating proposed capital budgeting projects. Based on these cash flows, determine this project’s PI (rounded to four decimal places):

0.5588

0.7058

0.5882

0.6764

Happy Dog Soap Company’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. (Reject or accept)

By comparison, the NPV of this project is ........... (-$916,329, -$733,063, -$1,007,962) . On the basis of this evaluation criterion, Happy Dog Soap Company should ........ (invest or not invest) in the project because the project ...... (will not or will) increase the firm’s value.

A project with a negative NPV will have a PI that is ........ (greater then 1.0, equal to 1.0 or less than 1.0) ; when it has a PI of 1.0, it will have an NPV ............. (Greater then $0, equal to $0 or less than $0)

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