Question

Please add the explanation.

9. Which of the following calculations takes the time value of money into account?

I. Payback

II. Average accounting return

III. Profitability index

A) I only

B) II only

C) III only

D) I and III only

E) II and III only

Answer 1

The right answer choice is “Option (c) III Only”

-Only the Profitability index method takes the time value of money into account.

-The Payback Period method and the Average accounting return shall not consider the time value of money while evaluating the capital budgeting decisions.

Profitability Index (PI) decision rule to evaluate the project

-The Project’s Profitability Index (PI) is the ratio of discounted annual cash inflows divided by its initial investment cost.

-The Profitability Index (PI) is calculated by dividing the present value of benefits by present value of costs

-It considers the relative size of the initial investment costs.

-Based on Profitability Index Analysis method, the Investment should be selected if the Profitability Index is greater than 1, else the Project should be rejected.

-If the Profitability Index (PI) is greater than 1, then the Project should be accepted.

-If the Profitability Index (PI) is less than 1, then the Project should be rejected.

The Payback period is calculated by using the following formula

Payback period = Initial Investment Cost / Annual cash inflows

The Average accounting return is calculated by using the following formula

Average accounting return = [Average net income / Average investment] x 100