Question

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 $2,500,000 in a project that is expected to generate the following net cash flows: 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): Year Cash Flow Year 1 $325,000 Year 2 $400,000 Year 3 $475,000 Year 4 $475,000 O O O O 0.4818 0.5353 0.5888 0.6156 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 . On the basis of this evaluation criterion, Happy Dog Soap Company should in the project because the project increase the firm's value.

Answer 1

Profitability index is calculated using the below formula:

Profitability Index= NPV + Initial investment/ Initial investment

Net present value can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$2,500,000.It is indicated the initial cash flow by a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the weighted average cost of capital of 9%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The net present value is -$1,161,873.74.

Profitability Index= -$1,161,873.74 + 2,500,000/ $2,500,000

                                   = $1,338,126.26/ / $2,500,000

                                   = 0.5353.

Based on project’s PI, the firm should reject the project.

By comparison, the NPV of the project is -$1,161,873.74. On basis of this criterion, Happy Dog Soap company should invest in the project because will not increase the firm’s value.

Based on the project PI, the firm should not invest in the project.

A project with a negative NPV, will have a PI that is less than 1.

In case of any query, kindly comment on the solution.