Question

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 $2,750,000 in a project that is expected to generate the following net cash flows: Year Year 1 Year 2 Year 3 Year 4 Cash Flow $350,000 $450,000 $475,000 $475,000 Happy Dog Soap Company 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): O 0.4847 0.6122 0.4592 O 0.5102 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. By comparison, the NPV of this project is in the project because the project . On the basis of this evaluation criterion, Happy Dog Soap Company should increase the firm's value. A project with a negative NPV will have a PI that is ; when it has a PI of 1.0, it will have an NPV

Answer 1

PI = PV of Cash Inflows / PV of Cash Outflows

Year	CF	PVF @9%	Disc CF
1	$ 3,50,000.00	0.9174	$   3,21,100.92
2	$ 4,50,000.00	0.8417	$   3,78,756.00
3	$ 4,75,000.00	0.7722	$   3,66,787.15
4	$ 4,75,000.00	0.7084	$   3,36,501.98
PV of Cash Inflows			$ 14,03,146.04
PV of Cash Outflows			$ 27,50,000.00
PI			0.5102

OPtion D is correct.

Firm SHould Reject the Project.

Year	CF	PVF @9%	Disc CF
1	$ 3,50,000.00	0.9174	$      3,21,100.92
2	$ 4,50,000.00	0.8417	$      3,78,756.00
3	$ 4,75,000.00	0.7722	$      3,66,787.15
4	$ 4,75,000.00	0.7084	$      3,36,501.98
PV of Cash Inflows			$    14,03,146.04
PV of Cash Outflows			$    27,50,000.00
NPV			-13,46,853.9573

NPV = PV of Cash Inflows - PV of Cash Outflows

NPV is - $1346853.96

Project with Negative NPV will have PI <1.

if PI = 1, NPV of Project will be "Zero"