Summary

Evaluation Inputs Required Decision Rule Does Adjust cash

Method the Rule flows for

For For Decision Accept Reject Time ? Risk ?

Calculation
Net present • Cash flows NPV NPV > 0 NPV < 0 Yes yes
Value(NPV) •Cost of
Capital(k)
Profitability •Cash flows PI PI > 1 PI < 1 Yes Yes
Index (PI) •Cost of
capital(k)
Internal Rate • Cash flows •IRR IRR > k IRR < k Yes Yes
of return(IRR) •Cost of
capital(k)
Discounted •Cash flows •DPP cut off DPP < DPP > Only Only within
Payback •Cost of period cutoff cutoff within DPP
period(DPP) capital (k) period period DPP
Payback •Cash flows •PP PP < PP > No No
period(PP) •Cutoff period cutoff cutoff
period period
• SK Manufacturing Company uses discounted payback period to
evaluate investments in capital assets. The company expects the
following annual cash flows from an investment of $3,500,000:

No salvage/residual value is expected. The

company’s cost of capital is 12%.
Required:
Compute discounted payback period of the
investment.
Discounted payback period = Years before full recovery + (Unrecovered cost at start of the year/Cash flow
during the year)
= 5 + (**$255,500/$456,300)
= 5 + 0.56
= 5.56 years
• Sunlight company needs a machine for its manufacturing process. The
cost of the new machine is $80,700. The expected useful life of the
machine is 8 years. At the end of 8-year period, the machine would
have no salvage value. After installation, the machine would increase
cash inflows by $30,000 per year. Sunlight is interested to know the
net preset value of the machine to accept or reject this investment.
The minimum required rate of return of the company is 16% on all
capital investments.
• Required:
• Compute net present value of the machine.
• Is it acceptable to purchase the machine?
(2) Purchase decision:
The positive net present value (computed above) indicates that the investment is profitable, therefore the
machine should be purchased

https://www.accountingformanagement.org/present-value-of-
an-annuity-of-1-in-arrear/
• A machine can reduce annual cost by $40,000. The cost of the
machine is 223,000 and the useful life is 15 years with zero residual
value.
• Required:
• Compute internal rate of return of the machine.
• Is it an acceptable investment if cost of capital is 16%?
• (1) Internal rate of return (IRR) computation:
• Internal rate of return factor = Net annual cash inflow/Investment
required
• = $223,000/$40,000
• = 5.575
• Now see internal rate of return factor (5.575) in 15 year line of the 
present value of an annuity if $1 table. After finding this factor, see
the corresponding interest rate written at the top of the column. It is
16%.  Internal rate of return is, therefore, 16%.
• (2) Conclusion:
• The investment is acceptable because internal rate of return promised
by the machine is equal to the cost of capital of the company.
The Martin Company is considering the four different investment opportunities. The selected information about
each proposal is given below:

The present value of cash inflows given above have been computed using a 10% discount rate. The company is
unable to accept all available projects because the funds available for investment are limited.
Required:
Compute the profitability index (present value index) for all the projects.
Rank the four investment projects according to preference using:
(a). net present value (NPV).
(b). profitability index (PI).
(c). internal rate of return (IRR).
Which one is the best approach for Martin Company to rank five competing projects?
(1). Computation of profitability index:
Formula of profitability/present value index is:
Profitability index = Present value of cash inflows/Investment required
Project 1: $1,134,540/$960,000 = 1.18
Project 2: $866,800/$720,000 = 1.20
Project 3: $672,280/$540,000 = 1.24
Project 4: $1,045,490/$900,000 = 1.16
Project 5: $759,520/$800,000 = 0.95

(2) Preference ranking of projects

3. The best ranking approach:

The best method of ranking projects depends on the availability of good reinvestment opportunities. Under internal rate of return
(IRR) method, we assume that the funds released from a project are reinvested in another project yielding the internal rate of
return equal to the previous project. According to IRR, the project 4 is ranked at number one with 19% IRR. It means any funds
released from project 4 must be reinvested in another project yielding an internal rate of return of at least 19% but It might be
difficult to find a project with such a high IRR.

The profitability index (PI) shows the present value of cash inflow generated by each dollar invested in a project. It assumes that
the funds released from a project are reinvested in another project with a return equal to the discount rate. In our problem, the
discount rate is only 10%. Generally, the profitability index is considered the most dependable method of ranking competing
projects.

The net present value (NPV) method considers the net present value figure but does not take into account the amount of
investment required for the project. Therefore, this method is not appropriate for comparing or ranking competing projects that
require different amounts of investment.  For example, project 3 is ranked at number four because of its low net present value but
it is the best option if we see at the present value of net cash inflow generated by each dollar invested in the project (as shown by
the profitability index).

Conclusion: From above discussion, we can conclude that the profitability index is the most appropriate and dependable method
of ranking projects for Martin Company.
The cost of a project is $50,000 and it generates cash inflows of $20,000, $15,000, $25,000 and $10,000 in
four years. Using present value index method, appraise profitability of the proposed investment assuming a
10% rate of discount.
 Solution
Calculation of present value and profitability index

Present Value
Year Cash Inflows Present Value
Factor
$ @10% $
1 20,000 .909 18,180
2 15,000 .826 12,390
3 25,000 .751 18,775
4 10,000 .683 6,830
56,175

Total present value = $56,175

Less: intial Outlay = $50,000
Net present value= $6,175
Profitability Index (gross) = Present value of cash inflows / intial cash outflow
= 56,175 / 50,000
= 1.1235
As the P.I. is higher than 1, the proposal can be accepted
Net Profitability = NPV / Initial cash outlay

= 6,175 / 50,000 = .1235

N.P.I. = 1.1235 – 1 = 0.1235
As the net profitability index is positive, the proposal can be accepted.
Problem
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
A (80) 20 0 10 25 20
B (20) 24 0 0 0 0
C (60) 50 20 (50) 70 (5)
D 100 0 (144) 0 0 0
E (200) 0 0 281 0 0

1. Calculate Payback for each project.

2. Which is the best project according to Payback?
3. Calculate the IRR of projects B and E.
4. Which is better according to IRR, project B or E?
5. Calculate the NPV of each project using a discount rate of 10%.
6. If you have unlimited funds, which is the best project according to NPV?
7. If you have unlimited funds, which projects should you do according to NPV?
8. If you have a limited budget, which is the best project according to NPV Profitability index?