CHAPTER FOUR

CAPITAL BUDGETING

Introduction
Capital budgeting refers to the process we use to make decisions concerning investments in the long-
term assets of the firm. The general idea is that the capital, or long-term funds, raised by the firms are
used to invest in assets that will enable the firm to generate revenues several years into the future.
Often the funds raised to invest in such assets are not unrestricted, or infinitely available; thus the firm
must budget how these funds are invested.

4.1 Importance of Investment Decisions:

Because capital budgeting decisions impact the firm for several years, they must be carefully planned. A
bad decision can have a significant effect on the firm’s future operations. In addition, the timing of the
decisions is important. Many capital budgeting projects take years to implement. If firms do not plan
accordingly, they might find that the timing of the capital budgeting decision is too late, thus costly with
respect to competition.

Decisions that are made too early can also be problematic because capital budgeting projects generally
are very large investments, thus early decisions might generate unnecessary costs for the firm.
Generating Ideas for Capital Budgeting- ideas for capital budgeting projects usually are generated
by employees, customers, suppliers, and so forth, and are based on the needs and experiences of the
firm and of these groups. For example, a sales representative might continue to hear from some of
his or her customers that there is a need for products with particular characteristics that the firm’s
existing products do not possess. The sales representative presents the idea to management, who in
turn evaluates the viability of the idea by consulting with engineers, production personnel, and
perhaps by conducting a feasibility study.

After the idea is confirmed to be viable in the sense it is saleable to customers, the financial manager must
conduct a capital budgeting analysis to ensure the project will be beneficial to the firm with respect to its value.

4.2. Project Classifications

Capital budgeting projects usually are classified using the following terms:
 Replacement decision - a decision concerning whether an existing asset should replace by a
newer version of the same machine or even a different type of machine that does the same thing
as the existing machine. Such replacements are generally made to maintain existing levels of
operations, although profitability might change due to changes in expenses (that is, the new
machine might be either more expensive or cheaper to operate than the existing machine).
 Expansion decision - a decision concerning whether the firm should increase operations by
adding new products, additional machines, and so forth. Such decisions would expand
operations.

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  Independent project- the acceptance of an independent project does not affect the acceptance of
any other project. For example, if you have a large sum of money in the bank that you would like
to spend on yourself, say, Birr.150, 000. You decide you are going to buy a car that costs about
Birr. 30,000 and a new stereo system for your house that costs less than Birr. 5,000. The decision
to buy the car does not affect the decision to buy the stereo-they are independent decisions.
 Mutually exclusive projects - in this case, the decision to invest in one project affects other
projects because only one project can be purchased. For example, if in the above example you
decided you were going to buy only one automobile, but you were looking at two different types
of cars, one is a Chevrolet and the other is a Ford. Once you make the decision to buy the
Chevrolet, you have also decided you are not going to buy the Ford.

4.3. Capital Budgeting Processes

Once a potential capital budgeting project has been identified, its evaluation involves the following six
steps:

1. First, the cost of the project must be determined

2. Next, management estimates the expected cash flows from the project, including the salvage value of
the asset at the end of its expected life.

3. Third, the riskiness of the projected cash flows must be estimated. This requires information about the
probability distribution (riskiness) of the cash flows.

4. Given the project’s riskiness, management determines the cost of capital at which the cash flows
should be discounted.

5. Next, the expected cash inflows are put on a present value basis to obtain an estimate of the asset’s
value.

6. Finally, the present value of the expected cash inflows is compared with the required outlay.

4.4 Capital budgeting (Techniques) Investment Evaluation Criteria

A. (Traditional) None discounted cash flow Techniques
I. Payback period
II. Average Accounting Return (AAR)

I.PAYBACK PERIOD
Payback period = Expected number of years required to recover a project’s cost. It is the length of time
it takes to recover the initial investment.

There are two cases under which the payback period is to be calculated:
1) If the project has even cash flow
Pay-back period = Initial investment
Annual cash inflows

2) If the project has uneven cash flow

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Merits of Pay-back method 3. Pay-back method reduces the possibility of
The following are the important merits of the loss on account of obsolescence.
pay-back method: Demerits
1. It is easy to calculate and simple to 1. It ignores the time value of money.
understand. 2. It ignores all cash inflows after the pay-back
2. Pay-back method provides further period.
improvement over the accounting rate return. 3. It is one of the misleading evaluations of
capital budgeting.
Accept /Reject criteria
If the actual pay-back period is less than the predetermined pay-back period, the project would be
accepted. If not, it would be rejected.
1) If the project has even cash flow
Example 4.1: Project cost is Br. 30,000 and the cash inflows are Br. 10,000, the life of the project is5
years. The predetermined payback period is 2 years and 6 months, Calculate the pay-back period?
Solution = PB = Br. 30,000
Br. 10,000 = 3 Years
Decision: The project should be rejected because actual payback period is greater (3 years) than
predetermined pay-back period (2& half year).
2) If the project has uneven cash flow
Example: If project requires an initial cash outflow of Br. 25,000. The cash inflows for 6years are Br.
5,000, Br. 8,000, Br. 10,000, Br. 12,000, Br. 7,000 and Br. 3,000. Calculate the payback period
predetermined period is 4 years?
Solution

Cumulative Cash
Year Cash Inflows (Br.)
Inflows (Br.)
1 5,000 5,000
2 8,000 13,000
3 10,000 23,000
4 12,000 35,000
5 7,000 42,000
6 3,000 45,000
The above calculation shows that in 3 years Br. 23,000 has been recovered Br. 2,000, is balance out of
cash outflow. In the 4th year the cash inflow is Br. 12,000. It means the pay-back period is three to four
years, calculated as follows:
Pay-back period = 3 years+2000/12000×12 months

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 = 3 years & 2 months.
Decision: The project should be accepted because actual payback period (3 years 2 months) is less than
predetermined pay-back period (4 years).
Exercises 4.1: The project A has the following information’s about cash inflows, outflows and
estimated life of the project.
Annual cash outflow Br. 100,000
Annual cash inflow Br. 25,000
6 years
Estimate Life

From the above particulars, compute:

1. Payback period?
2 can you accept or reject the project?

II. Accounting Rate of Return or Average Rate of Return (ARR):

The ARR is based on the accounting-concept of return on investment or rate of return. The ARR may be
defined as the annualized net income earned on the average funds invested in a project. In other words,
the annual returns of a project are expressed as a percentage of the net investment in the project.
Computation of ARR, Symbolically,

ARR= Average Annual-Profit (after tax)

Average investment in the project
This clearly shows that the ARR is a measure based on the accounting profit rather than the cash flows
and is very similar to the measure of rate of return on capital employed, which is generally used to
measure the overall profitability of the firm. The calculation of ARR may be further discussed with
reference to equal annual profits and unequal annual profits as follows:

Case A: Equal Profits

In case the expected profits (after tax) generated by a project are equal for all the years, and then the
annual profit itself is the average profit. So, this annual profit will be compared with the average
investment to find out the ARR as follows:

ARR = Annual Profit (after tax) x 100

Average Investment In the project

Case B: Unequal Profits

If the project is expected to generate unequal profits or uneven stream of profits over different years,
then the ARR may be calculated by finding out the average annual profits (by taking the simple
arithmetic mean of profits of different years) and then Comparing it with the average investment of the
project as follows:

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ARR = Average Annual Profit (after tax) x 100
Average Investment-In the project
In both the cases, the average investment of the ‘project, which is used as the denominator of the ARR
formula, is to be calculated. Are you aware what is this average investment and how is it to be
calculated?

Average Investment
The average investment refers to the average quantum of funds that remains invested or blocked in the
proposal over its economic life. The average investment of a proposal is affected by the method of
depreciation, salvage value and the additional working capital required by the proposal. The following
two approaches are available to calculate the average investment.

Initial Cash Outlay as Average Investment

In this case, the original cost of investment and the installation expenses if any, is taken as the amount
invested in the project. For example, a project costing Birr. 1,000,000 is expected to generate after tax
profit of Birr. 150,000 every year. The ARR for the proposal; would be 15 %( i.e. Birr. 150,000/ Birr.
1000,000 x 100). Theoretically, this approach of average investment seems to be good but taking the
initial cost as the average investment is definitely not correct on logical and technical grounds.

Average Annual Book Value after Depreciation as Average Investment

In this case, the average annual book allure (after depreciation) of the proposal is taken as the average
investment of the proposal. The following procedure may be adopted for this.
First, find out the opening book values and the closing book values of the project for all the years of its
economic life. The difference in the opening and closing values for a particular year will depend upon
the amount of depreciation for that year.

Second, find out the average book values for all the years by taking the simple arithmetic mean of the
opening and closing book values.

Third, find out the average of all the yearly averages. This average will be the average investment of the
proposal. However, the following points regarding depreciation are worth noting.

In case the firm has adopted a method of depreciation other than the straight-line method, then the above
procedure of finding out the average investment (i.e., by taking the average of the yearly average book
value) may be adopted. However, if the firm has adopted the straight-line method of depreciation to
write off the project over its useful economic life, then a shortcut method is also available as follows.

Short-cut Method to Find out the Average Investment If the firm provides depreciation as per straight
line method then the amount of depreciation for all the year would be same and is equal to (initial cost +
installation expenses – salvage value)/number of years. This amount of depreciation will be deducted

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from the opening book values to find out the closing book values for different years. The average of
these opening and closing book values will also decrease gradually every year by the amount of annual
depreciation such a case, the average investment of the proposal over its economic life can now be
calculated as: Average investment = 1/2(Initial Cost - Salvage value) + Salvage value. It may be noted
that in the above equation, the amount of salvage value has been first deducted and later added back.
The salvage value has been deducted to find out the annual amount of depreciation. However, this
amount of salvage value remains blocked in the proposal and is released only at the end of the economic
life of proposal. Therefore, the amount of salvage value has been added back to find out the average
investment. For example, ABC Ltd. takes a project costing Birr.120, 000 with expected life of 5-years
and the salvage value of Birr. 20,000. The average investment of the proposal is: Average investment =
1/2 (120,000 - 20,000) + 20,000 = Birr. 70,000
The average investment can also be calculated as follows:
Year Beginning book value Ending book value Average of book value
1 Br120,000 Br100,000 Br110,000
2 100,000 80,000 90,000
3 80,000 60,000 70,000
4 60, 000 40,000 50,000
5 40,000 20,000 30,000
Total 350,000
Average investment = Birr. 350,000/5 = Birr. 70,000
Table 4.1. Calculating average investment of the project

The Additional Working Capital

Sometimes, the project may also require additional working capital for its smooth operations. Though
this additional working capital will be released back, when the proposal will be scrapped and terminated,
yet this amount of additional working capital is blocked throughout the life of the project. So, this
additional working capital entails the investment of funds of the firm and should also be ‘added to the
average investment calculated as above. The average investment in any proposal (required to find out
the ARR) may therefore, be calculated as follows:
Average investment = 1/2(Initial Cost - Salvage value) + Salvage value + Additional Working Capital.

To continue with the above example, the project requires an additional working capital of Birr. 20,000
and is expected to generate annual average profit (after tax) of Birr. 18,000, then the aver-age
investment and the ARR can be calculated as follows:
Average investment = 1/2 (120,000 - 20,000) + 20,000 +20,000 = Birr. 90,000.
Therefore, accounting rate of return can be calculated as:

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Acceptance Rule:
Accept the project if Project’s ARR > Minimum Rate of Return
Reject the project if Project’s ARR < Minimum Rate of Return

The ARR calculated as above is compared with the pre-specified rate of return. Obviously, if the ARR is
more than the pre specified rate of return, then the project is likely to be accepted, otherwise not.
For example, in the above case the ARR of the proposal has been found to be 20%. In case, the firm
requires a rate of return of at least 18%, then this proposal is acceptable. However, if the minimum rate
of return of the firm is 22% then this proposal is likely to be rejected. The ARR can also be used to rank
various mutually exclusive proposals. The project with the highest ARR will have the top priority while
the project with the lowest ARR will be assigned lowest priority.

Merits of ARR
 It is easy to calculate and simple to
understand.
 It is based on the accounting information
rather than cash inflow (often used to
evaluate managers).
 It is not based on the time value of
money.
 It considers the total benefits associated
with the project.
Demerits of ARR
 It ignores the time value of money.
 It ignores the reinvestment potential of a
project.
 Different methods are used for
accounting profit. So, it leads to some
difficulties in the calculation of the
project.

Exercises 4.2: Suppose the Machine costs Br 500,000, has expected useful life 4 years, zero residual
value and expected to generate total net income Br 200,000. What is ARR? If the minimum rate of
return is 15% is the project should be accepted or otherwise rejected?

Exercises 4.3: A Dell computer company has two alternative proposals as of December 31, 2016. The
details of the proposals are as follows:

Proposal I Proposal II
Automatic Machine Ordinary machine
Cost of the machine Br. 220,000 Br. 60,000
Estimated life 5½ years 8 years
Estimated sales Br. 150,000 Br. 150,000
Costs : Material Br. 50,000 50,000
labor Br. 12,000 60,000
Variable Overheads Br. 24,000 20,000
Required: Compute the Accounting rate return (ARR) of the proposals under the return on investment
method neglecting tax and interest? Which investment has more ARR?

B. Discounted cash flow Techniques (modern project evaluation criteria’s)

A. Net present value (NPV)
B. Internal rate of return (IRR)

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 C. Profitability index (PI)

These methods are called time value of money approaches. The project evaluation should consider time
value of money because:
 The Time Value of Money says: a Birr today is worth more than a Birr tomorrow.
 It is necessary to convert future Birr into its equivalent present value Birr.

A. Net present value (NPV)

It is the difference between the present value of investments cash inflows (market value) and the present
value of its cash outflows (its cost). On the other hand NPV is the measure of how much value is created
or added today by undertaking an investment. Given our goal of creating value for stockholders, the
capital budgeting process can be viewed as a search for investments with positive NPVs. It is the most
important method for evaluating the project.

Reinvestment assumption
All cash flows generated by the project are immediately reinvested at the cost of capital

Three steps in calculating NPV

I. Identify the amount and time period of each cash flow associated with a potential investment
II. Discount the cash flows to their present values using a required rate of return (hurdle rate) with
NPV formula of:

𝑭𝑪𝑭𝟏 𝑭𝑪𝑭𝟐 𝑭𝑪𝑭𝟑 𝑭𝑪𝑭𝒏

𝑵𝑷𝑽 = (𝟏 𝒓)𝟏
+ (𝟏 + (𝟏 + ⋯ (𝟏 − 𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝒄𝒐𝒔𝒕) Where:
𝒓)𝟐 𝒓)𝟑 𝒓)𝒏
FCF = future cash flow
r = required rate of the return

III. Evaluate the net present value = the sum of all of the cash inflows less cash outflows with the
following decision rule:

The decision rule under the NPV method:

1. For a single project, take it if and only if its NPV is positive.
2. For many independent projects, take all those with positive NPV.
3. For mutually exclusive projects, take the one with positive and highest NPV.

Merits of NPV Demerits of NPV

1. It recognizes the time value of money.
2. It considers the total benefits arising out
of the proposal.
3. It is the best method for the selection of
mutually exclusive projects.
4. It helps to achieve the maximization of
shareholders’ wealth.
1. It is difficult to understand and calculate.
2. It needs the discount factors for
calculation of present values.
3. It is not suitable for the projects having
different effective lives.

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Example: 4.3: Suppose Alpha Company wants to invest on the one of the following mutually exclusive
projects with the data given in the following table:

Project name Project A Project B

Initial Investment Br. 20,000 Br 30,000
Estimated Life 5 years 5 years
Scrap Value Br. 1,000 Br 2,000

The estimated cash inflow that of the projects over their useful life is as follow:
Name of the project Year 1 Year 2 Year 3 Year 4 Year 5

A 5,000 10,000 Br. 10,000 3,000 2,000

B 20,000 10,000 5,000 3,000 2,000

Required: From the above information, calculate the net present value of the two projects and
suggest which of the two projects should be accepted if a discount rate of the two is 10%?

Solutions =
5000 10,000 10,000 1000
𝑁𝑃𝑉 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝐴 = + + +⋯ − 𝐵𝑟20,000
(1.1)1 (1.1)2 (1.1)3 (1.1)5
𝑁𝑃𝑉 = 𝐵𝑟24,227 − 20,000 = 4,227

20, 000 10,000 5,000 2000

𝑁𝑃𝑉 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝐵 = + + +⋯ − 𝐵𝑟30,000
(1.1)1 (1.1)2 (1.1)3 (1.1)5
𝑁𝑃𝑉 = 𝐵𝑟34,728 − 30,000 = 4,728

𝑫𝒆𝒄𝒊𝒔𝒊𝒐𝒏: 𝑇ℎ𝑒 𝐴𝑙𝑝ℎ𝑎 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 𝑠ℎ𝑜𝑢𝑙𝑑 𝑎𝑐𝑐𝑒𝑝𝑡 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝐵 𝑏𝑒𝑐𝑎𝑢𝑠𝑒 𝑖𝑡𝑠 𝑁𝑃𝑉 𝑖𝑠 ℎ𝑖𝑔ℎ𝑒𝑟

𝑡ℎ𝑎𝑛 𝑡ℎ𝑎𝑡 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝐴.

Exercise 4.2 .Suppose Hwassa Industrial park planned to invest on independent projects with cash flows
are given as follow:
Time A B
0 (10,000) (10,000)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

Required: what is the NPV of the projects? Can the projects accepted or rejected?

Exercise 4.3 .Suppose Dell computers PLC planned to invest on one of the following projects

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B. Internal Rate of Return (IRR) Ratio:
The internal rate of return method is another discounted cash flow technique which takes account of the
magnitude and timing of cash flows. Other terms used to describe the IRR method are yield on an
investment, marginal efficiency of capital, rate of return over cost time-adjusted rate of internal rate of
return and so on. The discount rate which equates the present value of an investment’s cash inflows and
outflows is its internal rate of return.
Reinvestment assumption: All cash flows generated by the project are immediately reinvested at the
IRR

Acceptance Rule:

Accept the project if Project’s IRR > k

Reject the project if Project’s IRR < k
Project may be accepted if IRR = k
Merits and Demerits of IRR;

Merits Demerits

1. Considers all cash flows, 1. Requires estimates of cash flows

2. True measure of profitability. which are a tedious task.
3. Based on the concept of time value 2. Does not hold the value-additively
of money. principle (i.e. IRRs of two or more
4. Generally, consistent with wealth projects do not add)
maximization principle. 3. At times fails to indicate correct
choice between mutually exclusive
projects.
4. At times yields multiple rates.
5. Relatively difficult to compute.

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5 Steps to be followed:

Step1. Estimate two rates

Step 2. Find out positive net present value
Step 3. Find out negative net present value
Step 4. Find out IRR =

Step 5. Make decision

Where = Base factor = Positive discount rate
DP = Difference in percentage

Example 4.4 A project costs Br. 16,000 and is expected to generate cash inflows of Br. 4,000 each 5
years. Calculate the Internal Rate of Return?
Solution

Step1. The rates estimated are 6% and 8%

Step 2. Find out positive net present value at 6% r

1
𝑁𝑃𝑉 = 𝐹𝐶𝐹 ∗ 1− – 𝐼𝑛𝑖𝑡𝑖𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
(1 + 𝑟)𝑛
𝑟

1
𝑁𝑃𝑉 = 4, 000 ∗ 1− − 16,000
(1.06)5
0.06
=
𝑁𝑃𝑉 𝑎𝑡 6% = 16,840 − 16,000 = 840 𝑤ℎ𝑖𝑐ℎ 𝑖𝑠 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒

Step 3. Find out negative net present value at 8% r

1
𝑁𝑃𝑉 = 4, 000 ∗ 1− − 16,000
(1.08)5
0.08

𝑁𝑃𝑉 𝑎𝑡 8% = 15,960 − 16,000 = −40 𝑤ℎ𝑖𝑐ℎ 𝑖𝑠 𝑛𝑒𝑔𝑎𝑡𝑖𝑣𝑒

Step 4. Calculate IRR

𝑃𝑜𝑠𝑖𝑡𝑣𝑒 𝑁𝑃𝑉
𝐼𝑅𝑅 = 𝐿𝑟 + ∗ ( 𝐻𝑟 − 𝐿𝑟)
𝑃𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑁𝑃𝑉 − 𝑁𝑒𝑔𝑎𝑡𝑖𝑣𝑒 𝑁𝑃𝑉

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 840
𝐼𝑅𝑅 = 6% + ∗ ( 2%)
840 − (−40

840
𝐼𝑅𝑅 = 6% + ∗ ( 2%)
880

𝐼𝑅𝑅 = 6% + 1.91%
𝐼𝑅𝑅 = 7.91%

To check that our IRR makes NPV = 0 Lets substitute 7.91% in the above NPV formula

:𝑁𝑃𝑉 = 4, 000 ∗ 1−( . ) − 16,000NPV= 4000*4.00 – 16000

.
NPV = 16,000 – 16, 0000

NPV = 0

Decision: Accept the project if the IRR is greater than or equal to the required rate of return (k).
Comparing NPV with IRR
Similarity: both consider time value of money into account.

Conflicting Rankings:

Conflicting rankings are conflicts in the ranking given a project by NPV and IRR, resulting from
differences in the magnitude and timing of cash flows.

One underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of
intermediate cash inflows—cash inflows received prior to the termination of the project.
NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they
are reinvested at the IRR.

Comparing NPV and IRR Techniques: Timing of the Cash Flow

Another reason why the IRR and NPV methods may provide different rankings for investment options
has to do with differences in the timing of cash flows. When much of a project’s cash flows arrive early
in its life, the project’s NPV will not be particularly sensitive to the discount rate.

On the other hand, the NPV of projects with cash flows that arrive later will fluctuate more as the
discount rate changes. The differences in the timing of cash flows between the two projects do not
affect the ranking provided by the IRR method.

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Comparing NPV and IRR Techniques: Magnitude of the Initial Investment
The scale problem occurs when two projects are very different in terms of how much money is required
to invest in each project. In these cases, the IRR and NPV methods may rank projects differently. The
IRR approach (and the PI method) may favor small projects with high returns (like the Br.2 loan that
turns into Br. 3).

The NPV approach favors the investment that makes the investor the most money (like theBr.1, 000
investments that yields Br.1, 100 in one day).

Comparing NPV and IRR Techniques: Which Approach is better?

On a purely theoretical basis, NPV is the better approach because:
NPV measures how much wealth a project creates (or destroys if the NPV is negative) for shareholders.
Certain mathematical properties may cause a project to have multiple IRRs—more than one IRR
resulting from a capital budgeting project with a nonconventional cash flow pattern; the maximum
number of IRRs for a project is equal to the number of sign changes in its cash flows.
Despite its theoretical superiority, however, financial managers prefer to use the IRR approach just as
often as the NPV method because of the preference for rates of return.

Which Methods Do Companies Actually Use?

A recent survey asked Chief Financial Officers (CFOs) what methods they used to evaluate capital
investment projects.
The most popular approaches by far were IRR and NPV, used by 76% and 75% (respectively) of the
CFOs responding to the survey.
These techniques enjoy wider use in larger firms, with the payback approach being more common in
smaller firms.

C. PROFITABILITY INDEX (PI)

The profitability index, or PI, method compares the present value of future cash inflows with the initial
investment on a relative basis. Therefore, the PI is the ratio of the present value of cash flows (PVCF) to
the initial investment of the project.

PVCF
PI 
Initial investment

Profitability Index (Benefit-Cost Ratio):

The ratio of the present value of the cash flows to the initial outlay is profitability index or benefit cost
ratio.
Acceptance Rule:
Accept the project if Project’s PI > 1
Reject the project if Project’s PI < 1

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Merits and Demerits of PI;
Merits
1. Considers all cash flows.
2. Recognizes the time value of money.
3. Relative measure of profitability.
4. Generally consistent with the wealth
maximization principle.
Demerits
1. Requires estimates of the cash flows which is a
tedious task.
2. At times fails to indicate correct choice between
mutually exclusive projects.

Example: Suppose the project A has initial cost of Br 100 and expected to produce Br 10, 60 and 80
over three years. What is profitability index of the project?
PVCF 118.79
PI  + (𝟏.𝟏)𝟑 /100   1.10
𝟏𝟎 𝟔𝟎 𝟖𝟎
+
Initial investment (𝟏.𝟏)𝟏 (𝟏.𝟏) 100

Decision: The project should be accepted because the profitability index of the project is greater than 1.

NPV Vs. PI
The NPV method and PI yield same accept – or reject rules, because PI can be greater than one
only when the project’s net present value is positive. In case of marginal projects, NPV will
zero and Pi will be equal to one. But a conflict may arise between of two methods if a choice
between mutually exclusive projects has to be made.

Consider the following illustration where the two methods give different raking to the
projects.
Project C Project D
PV of Cash inflows 100,000 50,000
Initial Cash outflows 50,000 20,000
NPV 50,000 30,000
PI 2.0 2.5

Project C should be accepted if we use the NPV method, but Project D is preferable according
to the PI. Which method is better?

The NPV method should be preferred, except under capital rationing, because the net present
value represents the net increase in the firm’s wealth. In our illustration, project C contributes
all that Project D contributes plus additional net present value of $ 20,000 ($ 50,000 - $ 30,000)
at an incremental cost of $ 50,000 ($ 100,000 - $ 50,000). As the net present value of project C’s
incremental outlay is positive, it should be accepted. Project C will also be acceptable if we
calculate the incremental profitability index.

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This is shown as follows:

Project C Project D Incremental Flow

PV cash flows 100,000 50,000 50,000
Initial Cash outflows 50,000 20,000 30,000
NPV 50,000 30,000 20,000
PI 2.0 2.5 1.67

Because of incremental investment has a positive net present value, $20,000 and a PI greater
than one, Project C should be accepted.

Z End of Chapter Four

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