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# Profitability Index- Capital Budgeting Techniques

Profitability Index Profitability index (PI) is the ratio of investment to payoff of a suggested project. It is a useful capital budgeting technique for grading projects because it measures the value created by per unit of investment made by the investor. This technique is also known as profit investment ratio (PIR), benefit-cost ratio and value investment ratio (VIR). The ratio is calculated as follows: Profitability Index = Present Value of Future Cash Flows / Initial Investment If project has positive NPV, then the PV of future cash flows must be higher than the initial investment. Thus the Profitability Index for a project with positive NPV is greater than 1 and less than 1 for a project with negative NPV. This technique may be useful when available capital is limited and we can allocate funds to projects with the highest PIs. Decision Rule: Rules for the selection or rejection of a proposed project: If Profit Index is greater than 1, then project should be accepted. If Profit Index is less than 1, then reject the project.

**Present Value of Multiple Cash Flows
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Present Value of Multiple Cash Flows We come across many cases where we have to determine the present value of series of multiple cash flows. There are two ways we can calculate present value of multiple cash flows. Either we discount back individual cash flow at a time, or we can just calculate the present values individually and add them up. Example:

000 more in two years. 2 and 3 respectively. inflation.08 =$9259.000 in one year and $15. how much we need to invest today to exactly earn this much in the future? In other words.082 Present value of $100 in 1 years at 8% is: $10.259 The total present value is : $12860.000/1. This technique is somewhat similar to payback period except that the expected future cash flows are discounted for computing payback period. The discounted payback period is 3 years. assume a company purchased a machine for $10000 which yields cash inflows of $8000.259=$22119. Thus. the PV of future cash inflows are cumulated up to time they cover the initial cost of the project. $2000. Discounted payback period is generally higher than payback period because it is money you will get in the future and will be less valuable than money today. etc. will take to cover the initial cost of the project. Present value of $15.341 Discounted Payback Period – Capital Budgeting Techniques Discounted Payback Period One of the limitations in using payback period is that it does not take into account the time value of money. the discounted payback period solves this problem. If we can earn 8% on this money. The regular payback period for this project is exactly 2 year. However.082 =$12860. future cash inflows are not discounted or adjusted for debt/equity used to undertake the project . what is the present value of two cash flows at 8%.Suppose if we want $10.082+$9259. it shows the breakeven after covering such costs. In this approach. Discounted payback period is how long an investment’s cash flows. For example. The cost of capital is 15%. But the discounted payback period will be more than 2 years because the first 2 years cumulative discounted cash flow of $8695.66 is not sufficient to cover the initial investment of $10000. discounted at project’s cost of capital.000 in 2 years at 8 percent is: $15000/1. . It considers the time value of money. and $1000 in year 1.

IRR is “The Discount rate at which the costs of investment equal to the benefits of the investment. IRR must exceed Cost of Capital. However this is not true in case of mutually exclusive projects. Decision Rule of Internal Rate of Return: If Internal Rate of Return exceeds the required rate of Return. The reason is that whenever NPV is positive . The problem with IRR come about when Cash Flows are non-conventional or when we are looking for two projects which are mutually exclusive. Internal Rate of Return – Capital Budgeting Techniques Internal Rate of Return Internal Rate of Return is another important technique used in Capital Budgeting Analysis to access the viability of an investment proposal. Under such circumstances IRR can be misleading. the investment should be accepted or should be rejected otherwise. but a higher NPV and should thus be accepted over the second project (assuming no capital rationing constraint). .Decision Rule of Discounted Payback: If discounted payback period is smaller than some pre-determined number of years then an investment is worth undertaking. One of the project requires a higher initial investment than the second project. NPV and IRR methods will always result identical accept/reject decisions for independent projects. Or in other words IRR is the Required Rate that equates the NPV of an investment zero. the first project may have a lower IRR value. Suppose we have to evaluate two mutually exclusive projects. This is considered to be most important alternative to Net Present Value (NPV).

Project Analysis ] Capital Budgeting Process Evaluation of Capital budgeting project involves six steps: • • • • • • First. It is considered as a method of analysis with serious limitations and qualifications for its use. compare the present value of expected cash flows with the required outlay. Otherwise. widely used by investors. 2010 2 Comments This item was filled under [ Capital Budgeting Process. the cost of that particular project must be known. Shorter payback periods are more desirable for the investors than longer payback periods. an investment of $5000 which returns $1000 per year will have a five year payback period. Capital Budgeting Process Posted by admin on 27 February. the project should be taken. Because it does not properly account for the time value of money. It is defined as the time period required for the investment’s returns to cover its cost. risk and other important considerations such as opportunity cost. Next determine the present value of expected cash flows. therefore. Finally. estimates the expected cash out flows from the project. . If the present value of the cash flows is greater than the cost. Second. Third. Payback period is easy to apply and easy to understand technique. For example. including residual value of the asset at the end of its useful life. Management find outs the cost of capital at which the cash out flows should be discounted. riskiness of the cash flows must be estimated. This requires information about the probability distribution of the cash outflows. it should be rejected. Based on project’s riskiness.Payback Period – Capital Budgeting Techniques Payback Period Payback period is the first formal and basic capital budgeting technique used to assess the viability of the project.

one must know important dos and don’ts regarding use of this tool. this would effect firms value positively.OR • If the expected rate of return on the project exceeds its cost of capital. that project is worth taking. A financial calculator is an ordinary calculator featuring few advanced and complex financial formulas so it can compute things like present value etc. How To Calculate Net Present Value? How to Calculate Net Present Value using Excel: . But one still have to understand the problem as the calculator just does some of the arithmetic and that is all. If the firm finds or creates an investment opportunity with a present value higher than its cost of capital. financial calculator are really helpful as they handle lot of the computation at their back-end. 2010 1 comment so far This item was filled under [ Capital Budgeting Basics ] How To Use Financial Calculator? Financial calculator is considered as easiest and less time consuming tool for computation of basic as well as advance financial analysis techniques. There are some common mistakes which make by people when they start using financial calculators. Therefore. These mistakes must be avoided as they can effect your decisions badly and make thing troublesome for you. How To Use Financial Calculator? Posted by admin on 12 February. Financial calculators are commonly used for determining loan payments but there are many other uses of financial calculators that don’t involve loan payments and interest rates. Firm’s stock price directly depends how effective are the firm’s capital budgeting procedures.

Suppose a company AtlanticWorld Co.000 50. should not include in the values arguments. The calculation of NPV is based on expected future cash flows of a project.000) 80. FCF 2………… FCF n) This function gives the NPV of an investment based on a discount rate and a series on cash outflows (future payments) and cash inflows (income). $ 50.53 .500 76. Example: Consider the following example to understand how NPV function works. FCF 1. if cash flows occur at the beginning of the period.600 over the next three years. and $76. The firm’s cost of capital is 12%. Consider the following example to understand how NPV function works.The calculation of net present value is useful when a business has to identify a viable investment opportunity. For example. the first value should be added to the NPV result.600 DESCRIPTION (B) Annual Discount Rate (Cost of Capital) Initial Cost of Investment Return from First Year Return from second Year Return from Third Year FORMULA =NPV(A1.A3.A5) =14.472.500. is considering an investment in a machine that costs $150. The simplest way is: By Use of NPV function in Excel: The NPV function consists of the following arguments: =NPV (Rate. DATA (A) 1 2 3 4 5 12% (150.000 and the additional cash inflows from the machine will be $80.000. There are many ways to calculate the NPV.A2.A4.

Once we have the estimated figures then we will estimate NPV as the difference between present value of cash inflows and the cost of investment. Net Present Value – Capital Budgeting Techniques Net Present Value Net Present Value measures the difference between present value of future cash inflows generated by a project and cash outflows during a specific period of time.g.472. there are various tools available to calculate the net present value e. by using tables and spreadsheets such as Microsoft Excel. Decision Rule: . The next step is to calculate the present value of these cash flows by applying the discounted cash flow (DCF) valuation procedures.Net Present Value of the Investment is $14. we first estimate the expected future cash flows from a project under consideration. With a help of net present value we can figure out an investment that is expected to generate positive cash flows. NPV Formula: NPV=Present Value of Future Cash Inflows – Cash Outflows (Investment Cost) In addition to this formula.53 As NPV of the purposed investment is positive so the company should invest in the machine. In order to calculate net present value (NPV).

When looking for money. Debt vs Equity Financing Equity equals Ownership (Share Profits and Control) Most small or growth-stage businesses use limited equity financing. That way you won't be over-leveraged to the point of jeopardizing your company's survival. Sometimes the bottom line is whether you would rather operate a successful business for several years and then sell your interests for a fair profit. . unless you retain a majority interest in the business and control over future sale of the business. the amount of equity financing that you undertake may depend more upon your willingness to share management control than upon the investor appeal of the business. the most common source of professional equity funding comes from venture capitalists. you must consider your company's financial strength. or industry colleagues. relatives. the easier it is to attract financing. Of course. If your firm has a high ratio of equity to debt. you should probably seek debt financing. By selling equity interests in your business. Debt vs Equity Financing Debt vs Equity Financing . experts advise that you should increase your ownership capital (equity investment) for additional funds. if your company has a high proportion of debt to equity. The most basic hurdle to equity financing is finding investors who are willing to buy into your business. customers. However. employees. The more money owners have invested in their business. However. and your personal motives for pursuing a small business will determine the value you place upon business ownership. however.There are two types of financing: equity and debt financing. or be repeatedly frustrated in attempts at financing a business that cannot achieve its potential because of insufficient capital. The effect of selling a large percentage of the ownership interest in your business may mean that your own investment will be short-term. As with debt financing. additional equity often comes from non-professional investors such as friends. many small business operators are not necessarily interested in maintaining their business indefinitely. you sacrifice some of your autonomy and management rights.A prospective investment should be accepted if its Net Present Value is positive and rejected if it is negative. Equity financing requires that you sell an ownership interest in the business in exchange for capital.