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:

Purple Whale Foodstuffs Inc. is considering investing $2,500,000 in a project that is expected to generate the following net cash flows:
Year Cash Flow
Year 1 $375,000
Year 2 $450,000
Year 3 $400,000
Year 4 $450,000
Purple Whale Foodstuffs Inc. uses a WACC of 10% when evaluating proposed capital budgeting projects. Based on these cash flows, determine this project’s PI (rounded to four decimal places):
a. 0.4755
b. 0.5547
c. 0.5283
d. 0.6075

Answer 1

The profitability index (PI) is calculated by finding the present value of future cash inflows, discounted by the WACC of 10%, and dividing by the initial investment. Summing the discounted cash flows for each year and dividing by the initial investment gives the PI. The correct option can be determined by matching the calculated PI with the provided options.

Step-by-step explanation:

The profitability index (PI) is a tool used in capital budgeting to evaluate investment opportunities. It is calculated by dividing the present value of future cash inflows by the initial investment outflow. To calculate the present value of the net cash flows for Purple Whale Foodstuffs Inc., we discount each year's cash flow by the company's Weighted Average Cost of Capital (WACC) of 10%.

The present value (PV) of the cash flows can be calculated using the formula:

PV = Cash Flow / (1 + WACC)n

Where 'Cash Flow' is in each respective year and 'n' is the year number. Once we calculate each year's present value, we sum them up and divide by the initial investment of $2,500,000 to get the PI.

After calculating, assuming the correct present values are determined, the PI can be looked up in the given options (a-d) to find the matching figure. If the calculated PI is not in the options provided, there might be a need to recheck the calculations.