Profitability index

Profitability index / Cost Benefit

It is the ratio between the present value of cash inflows to the present value of cash outflows PI = PV of cash inflows PV of cash outflows

ACCEPT REJECT RULE

ACCEPT IF PI > 1 REJECT IF PI < 1 MAY ACCEPT IF PI = 1

PAY BACK METHOD

PAY BACK METHOD

Pay back period is the time required to recover the original investment

Calculation of pay back period

Even cash flows

Uneven cash flows

Evaluation of Payback
1. It fails to take account of the cash inflows earned after payback period

Project X Y

CO C1 -4000 0 -4000 2000

C2 4000 2000

C3 Payback 2000 2 Yrs 0 2 Yrs

NPV 10% 806 -530

2. It does not consider all cash inflows yielded by a project. So it is not an appropriate method of measuring profitability

Evaluation of Payback
1. It fails to consider the magnitude and timing of cash inflows

project X Y

CO C1 -5000 3000 -5000 2000

C2 2000 3000

C3 2000 2000

Payback 2 Yrs 2 Yrs

NPV 10% 881 798

A company is considering an investment proposal to install new milling Controls at a cost of Rs 50,000. The facility has a life expectancy of 5 Years and no salvage value. The tax rate is 35 percent. Assume the firm Uses straight line depreciation and the same is allowed for tax purposes. The estimated cash flows before depreciation and tax from the Investment proposal are as follows

Year CFBDT 1 10,000 2 10,692 3 12,769 4 13,462 5 20,385 Compute Payback period, NPV at 10 %, PI at 10 % and IRR