User Account

All Pages

Another tool used to evaluate projects is called the

Assignment Help Finance Basics
Reference no: EM13483787

Another tool used to evaluate projects is called the profitability index (PI), or benefitcost ratio. This index is defined as the present value of the future cash flows divided by the initial investment. So, if a project costs $200 and the present value of its future cash flows is $220, the profitability index value would be $220/200

1.1. Notice that the NPV for this investment is $20, so it is a desirable investment. More generally, if a project has a positive NPV, then the present value of the future cash flows must be bigger than the initial investment. The profitability index would thus be bigger than 1 for a positive NPV investment and less than 1 for a negative NPV investment. How do we interpret the profitability index? In our example, the PI was 1.1. This tells us that, per dollar invested, $1.10 in value or $.10 in NPV results. The profitability index thus measures "bang for the buck," that is, the value created per dollar invested. For this reason, it is often proposed as a measure of performance for government or other not-for-profit investments. Also, when capital is scarce, it may make sense to allocate it to those projects with the highest PIs. We will return to this issue in a later chapter. The PI is obviously very similar to the NPV. However, consider an investment that costs $5 and has a $10 present value and an investment that costs $100 with a $150 present value. The first of these investments has an NPV of $5 and a PI of 2. The second has an NPV of $50 and a PI of 1.5. If these are mutually exclusive investments, then the second one is preferred even though it has a lower PI. This ranking problem is very similar to the IRR ranking problem we saw in the previous section. In all, there sems to be little reason to rely on the PI instead of the NPV. Our discussion of the PI is summarized as follows.

Avantages and Disadvantages of the Profitability Index

Advantages

Disadvantages

1. Closely related to NPV, generally

1. May lead to incorrect decisions in

comparisons of mutually exclusive

investments.

leading to identical decisions.

2. Easy to understand and communicate.

3. May be useful when available

 

investment funds are limited.

 

Questions:

a What does the profitability index measure?

b How would you state the profitability index rule?

Reference no: EM13483787

Questions Cloud

What is the payback period for the following set of cash : what is the payback period for the following set of cash flows?yearcash
On july 1 year 1 cody co paid 1198000 for 10 20-year bonds : on july 1 year 1 cody co. paid 1198000 for 10 20-year bonds with a face amount of 1 million. interest is paid on
What is the yield to call of the bond assume that interest : 1.a 5.50 percent coupon bond with 14 years left to maturity can be called in 4 years. the call premium is one year of
On january 1 dyer co acquired as a long-term investment a : on january 1 dyer co. acquired as a long-term investment a 20 common stock interest in eason co. dyer paid 700000 for
Another tool used to evaluate projects is called the : another tool used to evaluate projects is called the profitability index pi or benefitcost ratio. this index is
If beginning and ending goods in process inventories are : if beginning and ending goods in process inventories are 5500 and 15500 respectively and cost of goods manufactured is
Suggest the bonds of ibm coupon 1 term 3 years issued in : question 1 consider the bonds of ibm coupon 1 term 3 years issued in august 2010. why do investors buy these bonds with
What behavioral problems are associated with setting a : what behavioral problems are associated with setting a budget too loosely? what behavioral problems are associated with
In words what is the payback period the payback period rule : this project costs 500. what is the payback period for this investment? the initial cost is 500. after the first two

Reviews

Write a Review

Finance Basics Questions & Answers

  What coupon rate should be set on its bonds

A business wants to raise $1.2 million by selling some coupon bonds at par. Comparable bonds in the market have a 6.5 percent annual coupon, 15 years to maturity, and are selling at 97.687 percent of par. What coupon rate should be set on its bond..

  Recommendation to buy different u.s. growth stock funds

As an individual investor, you are attempting to invest in a well-diversified portfolio of mutual funds so that you will be somewhat insulated from any type of economic shock that may occur. Describe recommendation to buy four different U.S. growth s..

  Risk reduction and mergers

Two large, publicly owned firms are contemplating a merger. No operating synergy is expected. But, since returns on the 2 firms aren't perfectly positively correlated

  What is the current stock price

One year from today, investors anticipate that stock will pay a dividend of 3.25 per share

  What is the total cost for one year of holding

If Smith can hold marketable securities which yield 5 percent, and then convert these securities to cash at a cost of only the $2 deposit charge, what is the total cost for one year of holding the minimum cost cash balance according to the Baumol ..

  What is the book value and depreciation

The initial investment in equipment is $350,000 and the estimated salvage value is $18,000 after 7 years of operation. What is the book value and depreciation at t=6 using the declining balance method?

  Roles of international financial institutions

Would you please define the roles of international financial institutions (e.g. IMF, World Bank, ADB, etc.) and explain how they are used in global financing operations as well as describe their importance in managing risks.

  Find the discounted payback period for each project

Assume that the two projects are mutually exclusive and the cost of capital is 5%. Which project or projects should the company undertake? Base your results on the MIRR.

  Explain the trading techniques

Discuss and explain the trading techniques that can be used with financial futures noting how these securities can be used in conjunction with other investment vehicles including benefits and risks.

  Find the interest rate parity theorem

The one-year United State nominal interest rate is 4%. The one-year UK nominal interest rate is 2 percent. The indirect spot rate is currently 0.5350 Pounds per dollar.

  What is the after-tax cost of preferred stock

A firm is paying an annual dividend of $2.65 for its preferred stock which is selling for $57.00. There is a selling cost of $3.30. What is the after-tax cost of preferred stock if the firm's tax rate is 33%?

  Find the implied growth rate

The common stock of XYZ is expected to pay dividends of $1.25 next year and currently sells for $25. Assume that the firm's future dividend payments are expected to grow at a constant rate. Find the implied growth rate assuming that the required r..

Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

Submit Assignment

Academics

Major Subjects

Majors

Get In Touch

whatsapp: +1-415-670-9521

Phone: +1-415-670-9521

Email: [email protected]

TERMS & POLICIES

HELP & SUPPORT

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd