Extra Reading for further Comprehension

Net Present Value (NPV)

Net present value (NPV) of a project is the potential change in an investor's wealth caused by
that project while time value of money is being accounted for. It equals the present value of
net cash inflows generated by a project less the initial investment on the project. It is one of
the most reliable measures used in capital budgeting because it accounts for time value of
money by using discounted cash flows in the calculation.
Net present value calculations take the following two inputs:
 Projected net cash flows in successive periods from the project.
 A target rate of return i.e. the hurdle rate.
Where,
Net cash flow equals total cash inflow during a period, including salvage value if any, less cash
outflows from the project during the period.
Hurdle rate is the rate used to discount the net cash inflows. Weighted average cost of capital
(WACC)is the most commonly used hurdle rate.

Calculation Methods and Formulas

The first step involved in the calculation of NPV is the estimation of net cash flows from the
project over its life. The second step is to discount those cash flows at the hurdle rate.
The net cash flows may be even (i.e. equal cash flows in different periods) or uneven (i.e.
different cash flows in different periods). When they are even, present value can be easily
calculated by using the formula for present value of annuity. However, if they are uneven, we
need to calculate the present value of each individual net cash inflow separately.
Once we have the total present value of all project cash flows, we subtract the initial
investment on the project from the total present value of inflows to arrive at net present
value.
Thus we have the following two formulas for the calculation of NPV:

Decision Rule

In case of standalone projects, accept a project only if its NPV is positive, reject it if its NPV is
negative and stay indifferent between accepting or rejecting if NPV is zero.
In case of mutually exclusive projects (i.e. competing projects), accept the project with higher
NPV.

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 Examples

Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an
initial investment of $243,000 and it is expected to generate a cash inflow of $50,000 each
month for 12 months. Assume that the salvage value of the project is zero. The target rate of
return is 12% per annum.
Solution
We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%
Net Present Value
= $50,000 × (1 − (1 + 1%)^-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01^-12) ÷ 0.01 − $243,000
≈ $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
≈ $50,000 × 0.112551 ÷ 0.01 − $243,000
≈ $50,000 × 11.2551 − $243,000
≈ $562,754 − $243,000
≈ $319,754
Example 2: Uneven Cash Inflows: An initial investment of $8,320 thousand on plant and
machinery is expected to generate cash inflows of $3,411 thousand, $4,070 thousand, $5,824
thousand and $2,065 thousand at the end of first, second, third and fourth year respectively.
At the end of the fourth year, the machinery will be sold for $900 thousand. Calculate the net
present value of the investment if the discount rate is 18%. Round your answer to nearest
thousand dollars.
Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158
The rest of the calculation is summarized below:
Year 1 2 3 4

Net Cash Inflow $3,411 $4,070 $5,824 $2,065

Salvage Value 900

Total Cash Inflow $3,411 $4,070 $5,824 $2,965

× Present Value Factor 0.8475 0.7182 0.6086 0.5158

Present Value of Cash Flows $2,890.68$2,923.01$3,544.67$1,529.31

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Total PV of Cash Inflows $10,888

− Initial Investment − 8,320

Net Present Value $2,568 thousand

Strengths and Weaknesses of NPV

Strengths

Net present value accounts for time value of money which makes it a sounder approach than
other investment appraisal techniques which do not discount future cash flows such payback
period and accounting rate of return.
Net present value is even better than some other discounted cash flows techniques such as
IRR. In situations where IRR and NPV give conflicting decisions, NPV decision should be
preferred.

Weaknesses

NPV is after all an estimation. It is sensitive to changes in estimates for future cash flows,
salvage value and the cost of capital.
Net present value does not take into account the size of the project. For example, say Project A
requires initial investment of $4 million to generate NPV of $1 million while a competing
Project B requires $2 million investment to generate an NPV of $0.8 million. If we base our
decision on NPV alone, we will prefer Project A because it has higher NPV, but Project B has
generated more shareholders’ wealth per dollar of initial investment ($0.8 million/$2 million
vs $1 million/$4 million).

What is Net Present Value (NPV)?

Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the
entire life of an investment discounted to the present. NPV analysis is a form of intrinsic
valuation and is used extensively across finance and accounting for determining the value of a
business, investment security, capital project, new venture, cost reduction program, and
anything that involves cash flow.

Why is Net Present Value (NPV) Analysis Used?

NPV analysis is used to help determine how much an investment, project, or any series of cash
flows is worth. It is an all-encompassing metric, as it takes into account all revenues,
expenses, and capital costs associated with an investment in its Free Cash Flow (FCF).

In addition to factoring all revenues and costs, it also takes into the account the timing of each
cash flow that can result in a large impact on the present value an investment. For example,

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it’s better to have cash inflows sooner and cash outflows later, as opposed to the opposite of
that.

Why Are Cash Flows Discounted?

The cash flows in net present value analysis are discounted for two main reasons, (1) to
adjust for the risk of an investment opportunity, and (2) to account for the time value of
money (TVM).

The first point (to adjust for risk) is necessary because not all businesses, projects, or
investment opportunities have the same level of risk. Put another way, the probability of
receiving cash flow a US Treasury bill is much higher than the probability of receiving cash
flow from a young technology startup.

To account for the risk, the discount rate is higher for riskier investments and lower for safer
one. The US treasury example is considered to be the risk-free rate, and all other investments
are measured by how much more risk they bear relative to that.

The second point (to account for the time value of money) is required because due to
inflation, interest rates, and opportunity costs, money is more valuable the sooner it’s
received. For example, receiving $1 million today is much better than $1 million received five
years from now. If the money is received today, it can be invested and earn interest, so it will
be worth more than $1 million in five years’ time.

Net present value method (also known as discounted cash flow method) is a popular
capital budgeting technique that takes into account the time value of money.  It uses net
present value of the investment project as the base to accept or reject a proposed investment
in projects like purchase of new equipment, purchase of inventory, expansion or addition of
existing plant assets and the installation of new plants etc.

First, I would explain what is net present value and then how it is used to analyze investment
projects.

Net present value (NPV):

Net present value is the difference between the present value of cash inflows and the present
value of cash outflows that occur as a result of undertaking an investment project. It may be
positive, zero or negative. These three possibilities of net present value are briefly explained
below:

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Positive NPV:

If present value of cash inflows is greater than the present value of the cash outflows, the net
present value is said to be positive and the investment proposal is considered to be
acceptable.

Zero NPV:

If present value of cash inflow is equal to present value of cash outflow, the net present value
is said to be zero and the investment proposal is considered to be acceptable.

Negative NPV:

If present value of cash inflow is less than present value of cash outflow, the net present value
is said to be negative and the investment proposal is rejected.

The summary of the concept explained so far is given below:

The following example illustrates the use of net present value method in analyzing an
investment proposal.

Example 1 – cash inflow project:

The management of Fine Electronics Company is considering to purchase an equipment to be

attached with the main manufacturing machine. The equipment will cost $6,000 and will
increase annual cash inflow by $2,200. The useful life of the equipment is 6 years. After 6
years it will have no salvage value. The management wants a 20% return on all investments.

Required:

1. Compute net present value (NPV) of this investment project.

2. Should the equipment be purchased according to NPV analysis?

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Solution:

(1) Computation of net present value:

*Value from “present value of an annuity of $1 in arrears table“.

(2) Purchase decision:

Yes, the equipment should be purchased because the net present value is positive ($1,317).
Having a positive net present value means the project promises a rate of return that is higher
than the minimum rate of return required by management (20% in the above example).

In the above example, the minimum required rate of return is 20%.  It means if the equipment
is not purchased and the money is invested elsewhere, the company would be able to earn
20% return on its investment.  The minimum required rate of return (20% in our example) is
used to discount the cash inflow to its present value and is, therefore, also known as discount
rate.

Investments in assets are usually made with the intention to generate revenue or reduce costs
in future. The reduction in cost is considered equivalent to increase in revenues and should,
therefore, be treated as cash inflow in capital budgeting computations.

The net present value method is used not only to evaluate investment projects that generate
cash inflow but also to evaluate investment projects that reduce costs. The following example
illustrates how this capital budgeting method is used to analyze a cost reduction project:

Example 2 – cost reduction project:

Smart Manufacturing Company is planning to reduce its labor costs by automating a critical
task that is currently performed manually. The automation requires the installation of a new

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machine. The cost to purchase and install a new machine is $15,000. The installation of
machine can reduce annual labor cost by $4,200. The life of the machine is 15 years. The
salvage value of the machine after fifteen years will be zero. The required rate of return of
Smart Manufacturing Company is 25%.

Should Smart Manufacturing Company purchase the machine?

Solution:

According to net present value method, Smart Manufacturing Company should purchase the
machine because the present value of the cost savings is greater than the present value of the
initial cost to purchase and install the machine. The computations are given below:

*Value from “present value of an annuity of $1 in arrears table“.

Net present value method – uneven cash flow:

Notice that the projects in the above examples generate equal cash inflow in all the periods
(the cost saving in example 2 has been treated as cash inflow). Such a flow of cash is known
as even cash flow. But sometimes projects do not generate equal cash inflows in all the
periods. When projects generate different cash inflows in different periods, the flow of cash is
known as uneven cash flow. To analyze such projects the present value of the inflow of cash
is computed for each period separately. It has been illustrated in the following example:

 Example 3:

A project requires an initial investment of $225,000 and is expected to generate the following
net cash inflows:

Year 1: $95,000

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Year 2: $80,000

Year 3: $60,000

Year 4: $55,000

Required: Compute net present value of the project if the minimum desired rate of return is
12%.

Solution:

The cash inflow generated by the project is uneven. Therefore, the present value would be
computed for each year separately:

*Value from “present value of $1 table“.

The project seems attractive because its net present value is positive.

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Internal Rate of Return (IRR)

WHAT IT IS:

Internal rate of return (IRR) is the interest rate at which the net present value of all the
cash flows (both positive and negative) from a project or investment equal zero.

Internal rate of return is used to evaluate the attractiveness of a project or investment. If

the IRR of a new project exceeds a company’s required rate of return, that project is
desirable. If IRR falls below the required rate of return, the project should be rejected.

HOW IT WORKS (EXAMPLE):

The formula for IRR is:

0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n

where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and
IRR equals the project's internal rate of return.

Let's look at an example to illustrate how to use IRR.

Assume Company XYZ must decide whether to purchase a piece of factory equipment for
$300,000. The equipment would only last three years, but it is expected to generate
$150,000 of additional annual profit during those years. Company XYZ also thinks it can
sell the equipment for scrap afterward for about $10,000. Using IRR, Company XYZ can
determine whether the equipment purchase is a better use of its cash than its other
investment options, which should return about 10%.

Here is how the IRR equation looks in this scenario:

0 = -$300,000 + ($150,000)/(1+.2431) + ($150,000)/(1+.2431) 2 +

($150,000)/(1+.2431)  + $10,000/(1+.2431)4
3

The investment's IRR is 24.31%, which is the rate that makes the present value of the
investment's cash flows equal to zero. From a purely financial standpoint, Company XYZ
should purchase the equipment since this generates a 24.31% return for the Company
--much higher than the 10% return available from other investments.

A general rule of thumb is that the IRR value cannot be derived analytically. Instead, IRR
must be found by using mathematical trial-and-error to derive the appropriate rate.

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However, most business calculators and spreadsheet programs will automatically perform
this function.

[Click here to see How to Calculate IRR Using a Financial Calculator or Microsoft Excel]

IRR can also be used to calculate expected returns on stocks or investments, including

the yield to maturity on bonds.  IRR calculates the yield on an investment and is thus
different than net present value (NPV) value of an investment.

WHY IT MATTERS:

IRR allows managers to rank projects by their overall rates of return rather than their net
present values, and the investment with the highest IRR is usually preferred.  Ease of
comparison makes IRR attractive, but there are limits to its usefulness. For example, IRR
works only for investments that have an initial cash outflow (the purchase of
the investment) followed by one or more cash inflows.

Also, IRR does not measure the absolute size of the investment or the return. This means
that IRR can favor investments with high rates of return even if the dollar amount of the
return is very small. For example, a $1 investment returning $3 will have a higher IRR than
a $1 million investment returning $2 million. Another short-coming is that IRR can’t be
used if the investment generates interim cash flows. Finally, IRR does not consider cost of
capital and can’t compare projects with different durations.

IRR is best-suited for analyzing venture capital and private equity investments, which

typically entail multiple cash investments over the life of the business, and a single cash
outflow at the end via IPO or sale.

Internal rate of return (IRR) is the minimum discount rate that management uses to
identify what capital investments or future projects will yield an acceptable return and be
worth pursuing. The IRR for a specific project is the rate that equates the net present
value of future cash flows from the project to zero. In other words, if we computed the
present value of future cash flows from a potential project using the internal rate as the
discount rate and subtracted out the original investment, our net present value of the
project would be zero.

Definition – What is the Internal Rate of Return Ratio?

This sounds a little confusing at first, but it’s pretty simple. Think of it in terms of capital
investing like the company’s management would. They want to calculate what
percentage return is required to break even on an investment adjusted for the time value of
money. You can think of the internal rate of return as the interest percentage that company
has to achieve in order to break even on its investment in new capital. Since management
wants to do better than break even, they consider this the minimum acceptable return on
an investment.

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Formula
The IRR formula is calculated by equating the sum of the present value of future cash flow
less the initial investment to zero. Since we are dealing with an unknown variable, this is a
bit of an algebraic equation. Here’s what it looks like:

As you can see, the only variable in the internal rate of return equation that management
won’t know is the IRR. They will know how much capital is required to start the project and
they will have a reasonable estimate of the future income of the investment. This means we
will have solve for the discount rate that will make the NPV equal to zero.

Example
It might be easier to look at an example than to keep explaining it. Let’s look at Tom’s
Machine Shop. Tom is considering purchasing a new machine, but he is unsure if it’s the
best use of company funds at this point in time. With the new $100,000 machine, Tom will
be able to take on a new order that will pay $20,000, $30,000, $40,000, and $40,000 in
revenue.

Let’s calculate Tom’s minimum rate. Since it’s difficult to isolate the discount rate unless
you use an excel IRR caclulator. You can start with an approximate rate and adjust from
there. Let’s start with 8 percent.

As you can see, our ending NPV is not equal to zero. Since it’s a positive number, we need to
increase the estimated internal rate. Let’s increase it to 10 percent and recalculate.

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As you can see, Tom’s internal return rate on this project is 10 percent. He can compare
this to other investing opportunities to see if it makes sense to spend $100,000 on this
piece of equipment or investment the money in another venture.

Analysis
Remember, IRR is the rate at which the net present value of the costs of an investment
equals the net present value of the expected future revenues of the investment.
Management can use this return rate to compare other investments and decide what
capital projects should be funded and what ones should be scrapped.

Going back to our machine shop example, assume Tom could purchase three different
pieces of machinery. Each would be used for a slightly different job that brought in slightly
different amounts of cash flow. Tom can calculate the internal rate of return on each
machine and compare them all. The one with the highest IRR would be the best investment.

Since this is an investment calculation, the concept can also be applied to any other
investment. For instance, Tom can compare the return rates of investing the company’s
money in the stock market or new equipment. Now obviously the expected future cash
flows aren’t always equal to the actual cash received in the future, but this represents a
starting point for management to base their purchase and investment decisions on.

Like net present value method, internal rate of return (IRR) method also takes into
account the time value of money. It analyzes an investment project by comparing the
internal rate of return to the minimum required rate of return of the company.

The internal rate of return sometime known as yield on project is the rate at which an

investment project promises to generate a return during its useful life. It is the discount
rate at which the present value of a project’s net cash inflows becomes equal to the present
value of its net cash outflows. In other words, internal rate of return is the discount rate at
which a project’s net present value becomes equal to zero.

The minimum required rate of return is set by management. Most of the time, it is the
cost of capital of the company.

Under this method, If the internal rate of return promised by the investment project is
greater than or equal to the minimum required rate of return, the project is considered
acceptable otherwise the project is rejected. Internal rate of return method is also known
as time-adjusted rate of return method.

To understand how computations are made and how a proposed investment is accepted or
rejected under this method, consider the following example:

Example:

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The management of VGA Textile Company is considering to replace an old machine with a
new one. The new machine will be capable of performing some tasks much faster than the
old one. The installation of machine will cost $8,475 and will reduce the annual labor cost
by $1,500. The useful life of the machine will be 10 years with no salvage value. The
minimum required rate of return is 15%.

Required: Should VGA Textile Company purchase the machine? Use internal rate of return
(IRR) method for your conclusion.

Solution:

To conclude whether the proposal should be accepted or not, the internal rate of return
promised by machine would be found out first and then compared to the company’s
minimum required rate of return.

The first step in finding out the internal rate of return is to compute a discount factor
called internal rate of return factor. It is computed by dividing the investment required for
the project by net annual cash inflow to be generated by the project. The formula is given
below:

Formula of internal rate of return factor:

In our example, the required investment is $8,475 and the net annual cost saving is $1,500.
The cost saving is equivalent to revenue and would, therefore, be treated as net cash inflow.
Using this information, the internal rate of return factor can be computed as follows:

Internal rate of return factor = $8,475 /$1,500

= 5.650

After computing the internal rate of return factor, the next step is to locate this discount
factor in “present value of an annuity of $1 in arrears table“. Since the useful life of the
machine is 10 years, the factor would be found in 10-period line or row. After finding this
factor, see the rate of return written at the top of the column in which factor 5.650 is
written. It is 12%. It means the internal rate of return promised by the project is 12%. The
final step is to compare it with the minimum required rate of return of the VGA Textile
Company. That is 15%.

Conclusion:

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According to internal rate of return method, the proposal is not acceptable because the
internal rate of return promised by the proposal (12%) is less than the minimum required
rate of return (15%).

Notice that the internal rate of return promised by the proposal is a discount rate that
equates the present value of cash inflows with the present value of cash out flows as
proved by the following computation:

Payback Period

Payback period is the time in which the initial cash outflow of an investment is expected to
be recovered from the cash inflows generated by the investment. It is one of the simplest
investment appraisal techniques.

Formula

The formula to calculate payback period of a project depends on whether the cash flow per period from
the project is even or uneven. In case they are even, the formula to calculate payback period is:

Initial Investment
Payback Period =
Cash Inflow per Period
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and
then use the following formula for payback period:

B
Payback Period = A +
C

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In the above formula,
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
Both of the above situations are applied in the following examples.

Decision Rule

Accept the project only if its payback period is LESS than the target payback period.

Examples

Example 1: Even Cash Flows

Company C is planning to undertake a project requiring initial investment of $105 million.
The project is expected to generate $25 million per year for 7 years. Calculate the payback
period of the project.
Solution
Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷ $25M = 4.2 years
Example 2: Uneven Cash Flows
Company C is planning to undertake another project requiring initial investment of $50
million and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million
in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the
project.
Solution
(cash flows in Cumulative
millions) Cash Flow
Year Cash Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58
≈ 3.58 years

Advantages and Disadvantages

Advantages of payback period are:

1. Payback period is very simple to calculate.
2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a
project's life are considered more uncertain, payback period provides an indication of
how certain the project cash inflows are.

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3. For companies facing liquidity problems, it provides a good ranking of projects that
would return money early.
Disadvantages of payback period are:
1. Payback period does not take into account the time value of money which is a
serious drawback since it can lead to wrong decisions. A variation of payback method
that attempts to remove this drawback is called discounted payback period method.
2. It does not take into account, the cash flows that occur after the payback period.

Payback Period:

Under payback method, an investment project is accepted or rejected on the basis of

payback period. Payback period means the period of time that a project requires to recover
the money invested in it. It is mostly expressed in years.

Unlike net present value and internal rate of return method, payback method does not take
into account the time value of money.

According to payback method, the project that promises a quick recovery of initial
investment is considered desirable. If the payback period of a project is shorter than or
equal to the management’s maximum desired payback period, the project is accepted,
otherwise rejected. For example, if a company wants to recoup the cost of a machine within
5 years of purchase, the maximum desired payback period of the company would be 5
years. The purchase of machine would be desirable if it promises a payback period of 5
years or less.

Payback period formula – even cash flow:

When net annual cash inflow is even (i.e., same cash flow every period), the payback period
of the project can be computed by applying the simple formula given below:

*The denominator of the formula becomes incremental cash flow if an old asset (e.g.,
machine or equipment) is replaced by a new one.

Example 1:

The Delta company is planning to purchase a machine known as machine X. Machine X

would cost $25,000 and would have a useful life of 10 years with zero salvage value. The
expected annual cash inflow of the machine is $10,000.

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Required: Compute payback period of machine X and conclude whether or not the
machine would be purchased if the maximum desired payback period of Delta company is 3
years.

Solution:

Since the annual cash inflow is even in this project, we can simply divide the initial
investment by the annual cash inflow to compute the payback period. It is shown below:

Payback period = $25,000/$10,000

= 2.5 years

According to payback period analysis, the purchase of machine X is desirable because its
payback period is 2.5 years which is shorter than the maximum payback period of the
company.

Example 2:

Due to increased demand, the management of Rani Beverage Company is considering to

purchase a new equipment to increase the production and revenues. The useful life of the
equipment is 10 years and the company’s maximum desired payback period is 4 years.  The
inflow and outflow of cash associated with the new equipment is given below:

Initial cost of equipment: $37,500

Annual cash inflows:

Sales: $75,000

Annual cash Outflows:

Cost of ingredients: $45,000

Salaries expenses: $13,500

Maintenance expenses: $1,500

Non cash expenses:

Depreciation expense: $5,000

Required: Should Rani Beverage Company purchase the new equipment? Use payback
method for your answer.

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Solution:

Step 1: In order to compute the payback period of the equipment, we need to workout the
net annual cash inflow by deducting the total of cash outflow from the total of cash inflow
associated with the equipment.

Computation of net annual cash inflow:

$75,000 – ($45,000 + $13,500 + $1,500)

= $15,000

Step 2: Now, the amount of investment required to purchase the equipment would be
divided by the amount of net annual cash inflow (computed in step 1) to find the payback
period of the equipment.

= $37,500/$15,000

=2.5 years

Depreciation is a non-cash expense and has therefore been ignored while calculating
the payback period of the project.

According to payback method, the equipment should be purchased because the payback
period of the equipment is 2.5 years which is shorter than the maximum desired payback
period of 4 years.

Comparison of two or more alternatives – choosing from several alternative projects:

Where funds are limited and several alternative projects are being considered, the project
with the shortest payback period is preferred. It is explained with the help of the following
example:

Example 3:

The management of Health Supplement Inc. wants to reduce its labor cost by installing a
new machine. Two types of machines are available in the market – machine X and machine
Y. Machine X would cost $18,000 where as machine Y would cost $15,000. Both the
machines can reduce annual labor cost by $3,000.

Required: Which is the best machine to purchase according to payback method?

Solution:

Payback period of machine X: $18,000/$3,000 = 6 years

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Payback period of machine y: $15,000/$3,000 = 5 years

According to payback method, machine Y is more desirable than machine X because it has a
shorter payback period than machine X.

Payback method with uneven cash flow:

In the above examples we have assumed that the projects generate even cash inflow but
many projects usually generate uneven cash flow. When projects generate inconsistent or
uneven cash inflow (different cash inflow in different periods), the simple formula given
above cannot be used to compute payback period. In such situations, we need to compute
the cumulative cash inflow and then apply the following formula:

Example 4:

An investment of $200,000 is expected to generate the following cash inflows in six years:

Year 1: $70,000

Year 2: $60,000

Year 3: $55,000

Year 4: $40,000

Year 5: $30,000

Year 6: $25,000

Required: Compute payback period of the investment. Should the investment be made if

management wants to recover the initial investment in 3 years or less?

Solution:

(1). Because the cash inflow is uneven, the payback period formula cannot be used to
compute the payback period. We can compute the payback period by computing the
cumulative net cash flow as follows:

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 Payback period = 3 + (15,000*/40,000)

= 3 + 0.375

= 3.375 Years

*Unrecovered investment at start of 4th year:

= Initial cost – Cumulative cash inflow at the end of 3rd year

= $200,000 – $185,000

= $15,000

The payback period for this project is 3.375 years which is longer than the maximum
desired payback period of the management (3 years). The investment in this project is
therefore not desirable.

Advantages and disadvantages of payback method:

Some advantages and disadvantages of payback method are given below:

Advantages:
1. An investment project with a short payback period promises the quick inflow of
cash. It is therefore, a useful capital budgeting method for cash poor firms.
2. A project with short payback period can improve the liquidity position of the
business quickly. The payback period is important for the firms for which liquidity is
very important.

3. An investment with short payback period makes the funds available soon to invest
in another project.

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 4. A short payback period reduces the risk of loss caused by changing economic
conditions and other unavoidable reasons.

5. Payback period is very easy to compute.

Disadvantages:
1. The payback method does not take into account the time value of money.
2. It does not consider the useful life of the assets and inflow of cash after payback
period. For example, If two projects, project A and project B require an initial
investment of $5,000. Project A generates an annual cash inflow of $1,000 for 5
years whereas project B generates a cash inflow of $1,000 for 7 years. It is clear that
the project B is more profitable than project A. But according to payback method,
both the projects are equally desirable because both have a payback period of 5
years ($5,000/$1,000).

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What is Profitability Index?

The Profitability Index (PI) measures the ratio between the present value of future cash
flows to the initial investment. The index is a useful tool for ranking investment projects
and showing the value created per unit of investment.

The Profitability Index is also known as the Profit Investment Ratio (PIR) or the Value
Investment Ratio (VIR).

Profitability Index Formula

The formula for the PI is as follows:

or

Therefore:

 If the PI is greater than 1, the project generates value and the company should
proceed with the project.
 If the PI is less than 1, the project destroys value and the company should not
proceed with the project.

 If the PI is equal to 1, the project breaks even and the company is indifferent
between proceeding and not proceeding with the project.

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The higher the profitability index, the more attractive the investment.

Example of Profitability Index

Company A is considering two projects:

Project A requires an initial investment of $1,500,000 to yield estimated annual cash

flows of:

 $150,000 in Year 1
 $300,000 in Year 2

 $500,000 in Year 3

 $200,000 in Year 4

 $600,000 in Year 5

 $500,000 in Year 6

 $100,000 in Year 7

The appropriate discount rate for this project is 10%.

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Project B also requires an initial investment of $3,000,000 to yield estimated annual cash
flows of:

 $100,000 in Year 1
 $500,000 in Year 2

 $1,000,000 in Year 3

 $1,500,000 in Year 4

 $200,000 in Year 5

 $500,000 in Year 6

 $1,000,000 in Year 7

The appropriate discount rate for this project is 13%.

Company A is only able to undertake one project. Using the profitability index method,
which project should the company undertake?

Using the PI formula, Company A should do Project A. Project A creates value – every $1
invested in the project generates $.0684 in additional value.

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Discounting the Cash Flows of Project A:
 $150,000 / (1.10) = $136,363.64
 $300,000 / (1.10)^2 = $247,933.88

 $500,000 / (1.10)^3 = $375,657.40

 $200,000 / (1.10)^4 = $136,602.69

 $600,000 / (1.10)^5 = $372,552.79

 $500,000 / (1.10)^6 = $282,236.97

 $100,000 / (1.10)^7 = $51,315.81

Present value of future cash flows:

$136,363.64 + $247,933.88 + $375,657.40 + $136,602.69 + $372,552.79 + $282,236.97 +

$51,315.81 = $1,602,663.18

Profitability index of Project A: $1,602,663.18 / $1,500,000 = $1.0684. Project A creates

value.

Discounting the Cash Flows of Project B:

 $100,000 / (1.13) = $88,495.58
 $500,000 / (1.13)^2 = $391,573.34

 $1,000,000 / (1.13)^3 = $693,050.16

 $1,500,000 / (1.13)^4 = $919,978.09

 $200,000 / (1.13)^5 = $108,551.99

 $500,000 / (1.13)^6 = $240,159.26

 $1,000,000 / (1.13)^7 = $425,060.64

Present value of future cash flows:

$88,495.58 + $391,573.34 + $693,050.16 + $919,978.09 + $108,551.99 + $240,159.26 +

$425,060.64 = $2,866,869.07

Profitability index of Project B: $2,866,869.07 / $3,000,000 = $0.96. Project B destroys

value.

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Profitability Index

Profitability index is an investment appraisal technique calculated by dividing the present

value of future cash flows of a project by the initial investment required for the project.

Formula:
Profitability Index

Present Value of Future Cash Flows

= 
Initial Investment Required

Net Present Value

= 1 + 
Initial Investment Required

Explanation:

Profitability index is actually a modification of the net present value method. While present
value is an absolute measure (i.e. it gives as the total dollar figure for a project), the
profibality index is a relative measure (i.e. it gives as the figure as a ratio).

Decision Rule

Accept a project if the profitability index is greater than 1, stay indifferent if the
profitability index is 1 and don't accept a project if the profitability index is below 1.
Profitability index is sometimes called benefit-cost ratio too and is useful in capital
rationing since it helps in ranking projects based on their per dollar return.

Example

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Company C is undertaking a project at a cost of $50 million which is expected to generate
future net cash flows with a present value of $65 million. Calculate the profitability index.
Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required
Profitability Index = $65M / $50M = 1.3
Net Present Value = PV of Net Future Cash Flows − Initial Investment Required
Net Present Value = $65M-$50M = $15M.
The information about NPV and initial investment can be used to calculate profitability
index as follows:
Profitability Index = 1 + (Net Present Value / Initial Investment Required)
Profitability Index = 1 + $15M/$50M = 1.3

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