Question

Profitability Index

NPV/Initial Investment

Can you please give me a breakdown how to figure out NPV/Intitial investment. If you cab please just show me an example how to figure it out.

Answer 1

PRESENT VALUE OF CASH FLOW  = Its the value of all cash inflows expected to be generated from a project in future discounted at an required rate of return.

INITIAL INVESTMENT = Its the investment done in any project at its initial stage for example purchase price of a machinery etc. It can also include working capital requirement at initial stage or any other   cost required to get the project \ asset get started. it is also callled CASH OUTFLOW.

NPV ( NET PRESENT VALUE) = Its the present value of cash inflows adjusted for present value of cash outflows.

NPV = PRESENT VALUE OF CASH INFLOWS - PRESENT VALUE OF CASH OUTFLOW

PROFITABILITY INDEX = NPV \ INITIAL INVESTMENT

ACCEPT PROJECT ONLY  IF PROFITABILITY INDEX FOR THE PROJECT IS GREATER THEN 1 .

I am including and easy example

Q.. F Ltd. is interested in investing a project which requiring $50,000 as initial investment. It will generate cash inflows as

YEAR 1 = $20,000

YEAR 2= $29,000

YEAR 3 = $27,000

YEAR 4= $16,000

YEAR 5= $35,000

after that company will withdraw from the project. Evaluate the project using profitability index , cost of capital is 10%.

PRESENT VALUE OF CASH INFLOWS

YEAR	CASH INFLOW	PRESENT VALUE FACTOR @10%	PRESENT VALUE
1	20,000	0.909	18,180
2	29,000	0.826	23,954
3	27,000	0.751	20,277
4	16,000	0.683	10,928
5	35,000	0.621	21,735
			95,074

PRESENT VALUE OF CASH INFLOWS = 95,074

NPV = PRESENT VALUE OF CASH INFLOWS - PRESENT VALUE OF CASH OUT FLOWS

= 95,074 - 50,000

= 45,074

PROFITABILITY INDEX = NPV \ INITIAL INVESTMENT

= 45,074\ 50,000

= 0.9014

Since profitability index is less then 1 we should not invest in this project . If it has been a case of mutually exclusive projects to be evaluated on the basis of profitability index , we would have selected the project having highest profitability index.