Question

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 Happy Dog Soap Company:

Happy Dog Soap Company is considering investing $450,000 in a project that is expected to generate the following net cash flows:

Happy Doguses 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):

a)            3.0797

b)            3.3877

c)            2.6177

d)            2.7717

Year	Cash Flow
1	375,000
2	450,000
3	400,000
4	500,000

Happy Dog'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 or REJECT the project.

By comparison, the net present value (NPV) of this project is

a) -485,879

b) 1,123,055

c) 1,029,467

d) 748,703

e) 889,085

f) 935,879

On the basis of this evaluation criterion, Happy Dog should INVEST OR NOT INVEST in the project because the project WILL OR WILL NOT increase the firm’s value.

When a project has a PI greater than 1.00, it will exhibit an NPV equal to 0, Less than 0, Greater than 0; when it has a PI of 1.00, it will have an NPV equal to $0.

Projects with PIs Equal, Greater Than or Less 1.00 will exhibit negative NPVs.

Answer 1

Calculation of profitability index:
Time	PVF @9%	Amount	PV
1.00	0.9174	3,75,000.00	3,44,036.70
2.00	0.8417	4,50,000.00	3,78,756.00
3.00	0.7722	4,00,000.00	3,08,873.39
4.00	0.7084	5,00,000.00	3,54,212.61
			13,85,878.69
Profitability index= Present value of future cash flows/initital investment
=1385878.69/450000=3.0797
So correct answer is a)3.0797
As the profitability index is more than 1 so project should be accepted.
Calculation of Net present value:
Net present value= Present value of cash inflows-present value of cash outflow
= 1385878.69-450000=$935879
So correct answer is f)935879
As net present value is more than 1 so project should be accepted.