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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 projects cash inflows divided by the absolute value of its initial cash outflow. Consider this case:

Purple Whale Foodstuffs Inc. is considering investing $2,750,000 in a project that is expected to generate the following net cash flows:

Year Cash Flow

Year 1 $300,000

Year 2 $450,000

Year 3 $500,000

Year 4 $400,000

Purple Whale Foodstuffs Inc. uses a WACC of 10% when evaluating proposed capital budgeting projects. Based on these cash flows, determine this projects PI (rounded to four decimal places):

A) 0.4939

B) 0.4704

C) 0.4469

D) 0.5174

Purple Whale Foodstuffs Inc.s decision to accept or reject this project is independent of its decisions on other projects. Based on the projects PI, the firm should __________ (accept or reject) the project.

By comparison, the NPV of this project is ________ (-$1,602,160 / -$1,165,207 / -$1,456,509). On the basis of this evaluation criterion, Purple Whale Foodstuffs Inc. should __________(invest/not invest) in the project because the project _______ (will/will not) increase the firms value.

A project with a negative NPV will have a PI that is ________(equal to 1.0 / greater than 1.0 / less than 1.0); when it has a PI of 1.0, it will have an NPV _______ (equal to $0 / less than $0 / greater than $0).

Please answer all and fill in the blanks.

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