The profitability index (PI)is a capital budgeting tool that provides another wa

Question

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 Blue Moose Home Builders: Blue Moose Home Builders is considering investing $450,000 in a project that is expected to generate the following net cash flows: Blue Mooseuses 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 $275,000 Year 2 $450,000 Year 3 $400,000 Year 4 $475,000 2.5529 2.978:3 O 2.6947 2.8365 Blue Moose'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 criterion, Blue Moose should On the basis of this evaluation in the project because the project increase the firm's value When a project has a PI greater than 1.00, it will exhibit an NPV have an NPV equal to $0. Projects with PIs ; when it has a PI of 1.00, it will 1.00 will exhibit negative NPVs

Explanation / Answer

Profitability Index = Total Present value / Investment = 1276425 /  450000 = 2.8365..............final answer

Question - 2

The firm should accept the project

Question - 3

By comparsion the NPV of this project is positive On the basis of this evaluation criterion, Blue moose should INVEST in the project because the project NPV increase the firms value

Question - 4

When a project has a PI greater than 1.00 it will exhibit an NPV Positive;   when it has PI OF 1, it will have an NPV equal to 0. Projects with PI's less than 1.00 will exhibit negative NPV

Year    CF    DF PV 1 275000 0.917431 252293.6 2 450000 0.84168 378756 3 400000 0.772183 308873.4 4 475000 0.708425 336502     Total Present val 1276425

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