Question

2. State the criterion for accepting or rejecting independent projects under each of the following methods.

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

Answer 1

1) Profitability Index-

Profitability index is a measure to analyse the investment opportunity in several available investment alternatives.

This is calculated as follow-

PI = Present value of cashflow / Net initial investment

This ratio represents the PVof cashflow against the initial investment,

This ratio is higher the better,We should accept the investment opportunity if profitability index is more than 1.

Discounted Payback Period-

This is period in which our initial investment is recovered.Here the discounted cashflows are taken i.e time value of maoney is considered here.

A Discounted PBP should be lesser the best.In order to accept any investment we must ensure that the initial investment is recovered within the life of project.However the amount of cashinflows must be discounted before taking into the effect.

Accounting rate of return-

This is rate of return which a company desires to earn on its stockholders equity.

This rate of return must be greater than the desired level of Rate of return, in order to accept any particular offer of investment.

Net present value-

Net present value is present value of cash outflows and present value of cash inflows.In this the cashflows are adusyed to the time value of money using discount rates which are based on several measures of economy.

To accept any order in this measure the net present value must be positive.

Pay Back Period-

The PBP is the period in which our initial investment is recovered through the cash inflows earned from same investment.

Here the cashflows are not discounted for discount rates.

To accept the investment in this type of performance measure the PBP must be less than the period of investment project.

Interna rate of return-

This is a rate of return at which the present value of cash inflows are equal to present value of cashoutflow.

This rate must be greater than the rate of boorowings,in order to attract the particuar investment.

Please comment for any explanation,

Thanks,