Question

a)         Explain the following in relation to financial management principles and practices in JKUAT university Kitale CBD campus.

1. Profitability index                   [3 marks]
2. Payback period                       [3 marks]
3. Internal rate of return              [3 marks]
4. Accounting rate of return       [3 marks]
5. Net present value                    [3 marks]

Answer 1

(i)

PI = (NPV + initial investment) / initial investment.

The PI indicates the value created by the project. A PI higher than 1 indicates that the project creates value, and a PI less than 1 indicates that the project destroys value.

(ii)

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period = last year in which cumulative cash flow is negative + (cash flow required in next year for cumulative cash flows to equal zero / next year cash flow).

A shorter payback period indicates that the initial investment is recovered faster.

(iii)

IRR is the discount rate at which the project's NPV equals zero. If the project's IRR is higher than the project's WACC, the NPV will be positive, else it will be negative.

(iv)

ARR = average net profit / initial investment.

The drawback of ARR is that it does not consider the time value of money. However, it is simple to use.

(v)

NPV is the sum of present values of all the project's cash flows. A project with positive NPV creates value, whereas a project with negative NPV destroys value.