(A)

Profitability Index (PI ) and Net Present Value (NPV) are both discounted cash flow technique in capita
budgeting decision making process.

NPV :

NPV is method is the classic economic method of evaluating investment proposals. The method
recognizes the time value of money

NPV = Present value of cash inflows - Present value of cash outflow

NPV > 0 , investment would add value to the firm and project may be accepted.

NPV<0 , investment would subtract value from the firm and project should be rejected.

NPV = 0, investment would neither increase nor lose the value of firm, decision should be indifferent.

PI :

It is the ratio of the present value of cash inflows at the required rate of return to the initial cash outlays.

PV of cash inflow
It is a valuation of NPV rule. PI =
Initial cash Outlay

PI>1 , project should be accepted

Quantitative Analysis

Suppose Present value of cash inflow of a firm is Rs. 50 0000 and present value cash outflow is

Rs 250000 then we can calculate PI and NPV from the above formula :

500000
PI = =2
250000

NPV= 500000 – 250000 = RS. 250000

NPV technique is better than PI as NPV shows wealth at the end in absolute form, which will help to
make a decision clearly, whereas the same advantage is not available with PI method.

However, PI shows return over investment in times , which will be very useful for immediate decision
making.

In practice, over the years , company uses the technique of NPV for capital budgeting decision that PI
technique.
(B ) (i) Payback :

Initial Investment
Formula : Payback =
Annual cash flow

Project A : 10000/10000 = 1 Year

10000−7500 1
Project B : 1 + = 1 years
7500 3

10000−6000 1
Project C : 2 + = 2 years
12000 3

Project D : 1 year

(ii) ARR :

Average annual profits after taxes

Formula : ARR =
Average investment

(10000−10000) /2
Project A : =0
10000/2

(15000−10000) /2 2500
Project B : = = 50%
10000/2 5000

(18000−10000) /2 2667
Project C : = = 53%
10000/2 5000

(16000−10000)/2 2000
Project D : = = 40%
10000/2 5000

(iii) IRR :

The discount rate which equates the present values of an investment’s cash inflows is its
internal rate of return.

Project A : The net cash inflow is just equal to initial investment in the 1 st year. So IRR (r) = 0%

Project B : We can calculate considering the case of annuity. Present value of annuity factor is

= 10000/7500 = 1.333. If we look the annuity table then this factor we found in 2
year column under 32%. Therefore r = 32%
 Project C : Since cash flows are unequal , trial and error method we need to apply . We have to

calculate fake payback period first.

2000+4000+12000
Average cash inflow = = Rs. 6000
3

Initial cash flow 10000

Fake Payback period = = = 1.667
Average cash flow 6000

We locate 1.667 lies nearest to 1.696 in 3 years row which is annuity of Rs.1 at 35%

Now we have to calculate NPV at the first discount rate at 35%

PV of cash inflow

Year Cash Inflow Discount factor Present value

1 2000 0.741 1482
2 4000 0.549 2196
3 12000 0.406 4872
8496
NPV = 8496-10000 = - 1504

Now we have to find out NPV at some other discount rate, it should be more than 35% or less
than 35% . since NPV is negative other discount rate should be less than 35%.

To get correct IRR from the formula below , one NPV should be negative and other one should
be positive.

So let us second discount rate at 25%

PV cash of cash flow

Year Cash Inflow Discount factor Present value

1 2000 0.800 1600
2 4000 0.640 2560
3 12000 0.524 6288
10448
NPV = 10448-10000 = 448

Apply the below formula of IRR

IRR =
NPV at lower discount rate
Lower discount rate +
NPV at lower discount rate−NPV at higher discount rate
x( difference in
discount rates)
 448
= 25 + x 10
448+1504

= 27.29 %

Project D : Since cash flows are unequal , trial and error method we need to apply . We have to
calculate fake payback period first.

10000+3000+3000
Average cash inflow = = Rs. 5333
3

Initial cash flow 10000

Fake Payback period = = = 1.875
Average cash flow 5333

We locate 1.875 lies nearest to 1.896 in 3 years row which is annuity of Rs.1 at 27%

Now we have to calculate NPV at the first discount rate at 27%

PV of cash inflow

Year Cash Inflow Discount factor Present value

1 10000 0.787 7870
2 3000 0.620 1860
3 3000 0.488 1464
11194
NPV = 11194-10000 = 1194

Now we have to find out NPV at some other discount rate, it should be more than 27% or less
than 27% . since NPV is positive other discount rate should be more than 27%.

To get correct IRR from the formula below , one NPV should be negative and other one should
be positive.

So let us second discount rate at 40%

PV cash of cash flow

Year Cash Inflow Discount factor Present value

1 10000 0.714 71400
2 3000 0.510 1530
3 3000 0.364 1092
9762
NPV = 9762-10000 = -238

Apply the below formula of IRR

 IRR =
NPV at lower discount rate
Lower discount rate +
NPV at lower discount rate−NPV at higher discount rate
x( difference in
discount rates)

1194
= 27 + x 13
1194+238

= 37.83 %

(iV) NPV

Project A :

Discounted @10% Discounted @ 30%

Yea
r Cash flow Discount rate PV Year Cash flow Discount rate PV
0 10000 1 10000 0 10000 1 10000
1 10000 0.909 9090 1 10000 0.769 7690
2 0   0 2 0   0
3 0   0 3 0   0
NVP     -910 NPV     -2310

Project B :

Discounted @10% Discounted @ 30%

Yea
r Cash flow Discount rate PV Year Cash flow Discount rate PV
0 10000 1 10000 0 10000 1 10000
1 7500 0.909 6817.5 1 7500 0.769 5767.5
2 7500 0.826 6195 2 7500 0.592 4440
 3 0   0 3 0   0
NVP     3012.5 NPV     207.5

Project C :

Discouned @10% Discounted @ 30%

Yea
r Cash flow Discount rate PV Year Cash flow Discount rate PV
0 10000 1 10000 0 10000 1 10000
1 2000 0.909 1818 1 2000 0.769 1538
2 4000 0.826 3304 2 4000 0.592 2368
3 12000 0.751 9012 3 12000 0.455 5460
NVP     4134 NPV     -634

Project D :

Discounted @10% Discounted @ 30%

Yea
r Cash flow Discount rate PV Year Cash flow Discount rate PV
0 10000 1 10000 0 10000 1 10000
1 10000 0.909 9090 1 10000 0.769 7690
2 3000 0.826 2478 2 3000 0.592 1776
3 3000 0.751 2253 3 3000 0.455 1365
NVP     3821 NPV     831

The projects are ranked as follows according to the various methods :

Projec
t Ranks
AR IR
  Payback R R NPV @10% NPV @30%
A 1 4 4 4 4
B 2 2 2 3 2
C 3 1 3 1 3
 D 1 3 1 2 1

(b) Payback and ARR are non – discounted cash flow technique and theoretically unsound methods
for choosing the investment projects whereas the NPV and IRR are the discounted cash flow
technique which gives consistent results. If the projects are independent either IRR or NPV can
be used since same of projects will be accepted by any of the methods. In the present case all
the three Project (B,C,D) are accepted if 10% discount factor considered except project A. In case

of 30 % discount factor the project B and Project D are considered.

If we assume the projects are mutually exclusive, then under the assumption of 30% discount rate,
the choice will be between Project B and Project D , since A and C are unprofitable. Both criteria ,
IRR & NPV gives same results. i,e Project D will be the best. Under the assumption of 10% discount
rate ranking according to IRR and NPV conflict (except for project A). if we follow the IRR rule ,
Project D is to be accepted. But if we consider the NPV rule the we can see that Project C is more
profitable. The NPV gives consistent results inconformity with the wealth maximization . We
would therefore accept Project C following the NPV rule.