In: Accounting
1) The net present value method is used to evaluate capital investments. Describe this method. Be sure to address why the time value of money is an important component.
2)Describe the payback period method of analyzing an investment. What are two drawbacks to this method?
3) What is the profitability index? Why is this better than the net present value method when you’re trying to compare investments of different sizes?
1)Net Present Value Method
It is method of capital budgeting which considers time value of money by including the time factor as one one of its component. this method includes the following steps-
a) find out the minimum rate of return that should be selected as the discount rate. this rate should either be equal to actual interest rate in market on long term loans or should indicate the opportunity cost of capital of investor.
b)then find out present value of cash outflows at discount rate calculated above.
c) after this find out the present value of cash inflows (after tax before depreciation) at the calculated discount rate.
d)find npv. NPV= Present value of cash outflows-Present value of cash inflows
(present value=1/((1+discount rate)^number of years)
e)accept/ reject the proposal
if NPV>0 accept
if NPV<0 reject
if NPV=0 may accept/reject
projects with higher NPV should be selected.
the discount rate used reflects the importance of time value of money as all the future values are converted to present values using this discount rate.
2)Payback period method
It is a method of capital budgeting which is used to determine the period in which the investment in fixed assets will payback itself.
formula
payback period=original cost of asset/ annual cash inflows
(annual cash flows is the annual net profits after tax but before depreciation)
evaluation of investment
a)under this method, firstly payback period of all investments are calculated .
b)investments are ranked according to the payback period in such a way that the investment having shorter period will be preferred over the other.
c)if there is only one investment proposal then then payback period of that proposal is compared with the benchmark payback period and in this case proposal will be accepted only if calculated payback period is lesser or equal to benchmark period.
drawbacks
a)it ignores the time value of money as it does not consider magnitude and timing of cash inflows.
b)it does not consider the profits earned after the payback period due to which true profitability can not be ascertained.
3) profitability index
it is also known as benefit cost ratio method. It measures relationship between present value of cash inflows and present value of cash outflows.
formula
profitability index= present value of cash inflows/ present value of cash outflows
another formula
profitability index=npv/ initial cash outflow
if PI>1 accept the proposal
if PI<1 reject the proposal
profitability index method is preferred over npv method in case of different size of investments
it can be explained with the help of an example. lets assume the two projects X and Y gives same NPV of 20,000 but projects Xand Y have initial costs 50,000 and 60,000 respectively.
PI of X=20,000/50,000=0.4
PI of Y=20,000/60,000=0.3
according to PI method project X should be preferred over Y. But according to NPV method both projects have equal ranking and any of them can be chosen.
thus, when project size differ PI method proves to be superior than NPV method.