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Outline
Profitability index
Typical steps
1.
Generating ideas
2.
3.
4.
Categories/classifications
1.
Replacement projects
2.
Expansion projects
3.
4.
Basic assumptions
1.
2.
3.
4.
5.
A sunk cost is one that has already been incurred. You cannot
change a sunk cost.
Normally, this method is used as a rough guideline at the early stage of capital
budgeting analysis.
50,000
10,000
30,000
40,000
20,000
30,000
30,000
30,000
30,000
20,000
40,000
30,000
10,000
50,000
30,000
For cash flow A, by the end of year two, the cash flow generated is
RM90,000, just short of RM10,000 of recouping the initial investment.
Therefore, the payback period is 2 + 10,000/30,000 = 2.33 years.
For cash flow B, the payback period is 4 years, while for cash flow C, the
payback period is 3.33 years.
If a company has a minimum criteria for payback period of say, 3 years, then
cash flow A is preferred compared to cash flow B and cash flow C.
Year
1
2
3
4
5
This is much longer than the 2.33 years obtained earlier without discounting.
This method still has other weaknesses such as does not take into account
the cash flow after the break-even point and also the timing and scale
problem.
Year 1
Year 2
Year 3
Year 4
Year 5
Sales
100,000
150,000
240,000
130,000
80,000
Cash expenses
50,000
70,000
120,000
60,000
50,000
Depreciation
40,000
40,000
40,000
40,000
40,000
EBT
10,000
40,000
80,000
30,000
-10,000
Taxes (40%)
4,000
16,000
32,000
12,000
-4,000
Net income
6,000
24,000
48,000
18,000
-6,000
The net present value (NPV) is by far the most popular capital
budgeting technique for several reasons.
50,000
10,000
30,000
40,000
20,000
30,000
30,000
30,000
30,000
20,000
40,000
30,000
10,000
50,000
30,000
Assuming that the cost of capital (discount rate) is 10%, then the
NPVs for the projects are as follows.
The profitability index (PI) is similar to the NPV, except that it shown as
a ratio, or index, instead of a dollar amount. The formula for
profitability index is as follows.
PI above 1.00 shows that the NPV is positive (>), therefore the project will be accepted,
and PI below 1.00 shows that the NPV is negative, therefore the project will be rejected.
The strengths of profitability index technique are similar to that of the NPV technique.
However, since PI is expressed in the form of a ratio or index, it may have a problem in
terms of projects cash flow scale. For example, lets look at the following projects:
Notice that the PI of project A will remain the same (1.20), while the
NPV is now RM11,000. Therefore, the assumptions and also
properties of each project are important before making a decision
on any capital budgeting technique.
The internal rate of return is the rate that equates the NPV with zero
or the discount rate that will make the present value of the cash flows
equal to the initial outlay.
Also called hurdle rate, because the discount rate has to be lower
than the IRR for the project to have a positive. Therefore, if the IRR is
higher than the cost of capital, the project will be accepted and if the
IRR is lower than the cost of capital, the project will be rejected. The
general formula to find the IRR is as follows.
In order to solve for the IRR above, we need to use the similar
approach in finding the YTM in the Bond Valuation chapter earlier,
which is using a combination of trial-and-error and also interpolation
technique. Using the example of cash flow B earlier,
At 12%,
Since it is still above 0, we still have to try another rate, say 13%.
At 13%,
Now we can interpolate between the two rate: 12% and 13%:
NPV
0.12
17
IRR
0.13
-3,025.25
Since the IRR (12.01%) is higher than the cost of capital (10%), the
project has a positive NPV and is thus accepted.