12. Profitability Index action-takeQuiz&quiz; probGuid-QNAPCOA801010000003 af926
ID: 2787311 • Letter: 1
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12. Profitability Index
action-takeQuiz&quiz; probGuid-QNAPCOA801010000003 af926e00d00008ctx-mayest-0006&kck-m.; Keep the Highest: (7 Attempts: 12. Profitability index AaAa Estimating the cash flow generated by $1 invested in investment The profitability index (Pt)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 ife (the project's expected benefets) to its net cost NINV) A project's PI value can be interpreted to indicate a project's discounted returm generated by each dollar of net investment required to generate those returns. Consider the case of Fuzzy Badger Transport Company: Fuzzy Badger Transport company is considering investing $600,000 in a project that is expected to generate the following net cash flows Fuzzy Badgeruses a WACC of 10% when evaluating proposed capital budgeting projects. Based on these cash flows, determine this project's PI (rounded to four Year Cash Flow Year 1 $325,000 Year 2 $400,000 year 3 $425,000 Year 4 $450,000 decimal places): O 2.2966 O 1.8790 O 2.0878 O 1.9834 Fuzzy Badger'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. accept reject on the basis of this evaluation By comparison, the net present value (NPV) of this praject is criterion, Fuzzy Badper should in the project because the project will not increase the firm's value ; when it has a PI of 1.00, it wi When a project has a Pi greater than 3.00, it wil exhibit an NPV have an NPV equal to so. Projects with PIs 3,00 will exh biz negative NPvsS 0Explanation / Answer
PV of Benefits = 325,000/1.10 + 400,000/1.102 + 425,000/1.103 + 450,000/1.104
= 295,455 + 330,578 + 319,309 + 307,356
=$1,252,698
PV of Investment =$600,000
Profitability Index =$1,252,698/$600,000 =2.0878
Hence, Option-(c) is correct.
b.) Based on PI criteria, the firm should Invest in the project.
c.) NPV of the Project =$1,252,698 - 600,000 =$652,698
d.) On the basis of NPV, the firm should Invest in the project because it will increase firms value.
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