Question

A company is analyzing a variety of potential investments using different capital budgeting methods. Which of the following represents the most profitable choice based on the information provided?

Select one:

a. The company picks a project with a 5 year payback period over one with a 3 year payback period.

b. The company picks a project with profitability index of 1.25 over a project with a PI of -.25.

c. The company picks a project with an NPV of $250,000 over one with an NPV of $300,000.

d. The company picks a project with an accounting rate of return 5% over one with an ARR of 3%.

Answer 1

The most profitable choice is choice (b) where the company picks a project with PI of 1.25 over PI of -0.25 because a project is worth selecting only if the profitability index i.e PV of future cash flows/ Initial investment is positive and greater than 1. Negative PI indicates NPV (net present value) of the project being negative i.e. the project can't cover initial investment.

-Choice (a):- Payback period measures the time required for the annual cash flows of a project to recover initial investment. Lower the Payback period, better the project. Thus, choosing 5 year payback period over 3 is incorrect.

-Choice (c):-NPV= Present value of future cash flows- Initial investment. Thus, higher the NPV, better the project. Thus, choosing $250,000 NPV over $300,000 is incorrect.

-Choice (d):- Accounting rate of return (ARR)= Profit/ Investment. Higher the ARR, better the project. But ARR is not an appropriate measure of capital budgeting since it takes into account Profit rather than cash flows and also doesn't take into account time value of money. Thus even a project with ARR of 5% can't be said to be better because of the above drawbacks.