PI and NPV.ppt for entrepreneurship, very imp

entrepreneurship

1. Profitability Index
1
Theprofitabilityindex(PI)isanappraisaltechnique
appliedtopotentialcapitaloutlays.
Profitabilityindex(PI),alsoknownasprofitinvestment
ratio(PIR)andvalueinvestmentratio(VIR),istheratio
ofpayofftoinvestmentofaproposedproject.
Conditions:
If PI > 1……….so project would be accepted
If PI < 1……….so project would be rejected
IfPI=1……….soprojectwouldbeonbreakeven

2. Formula
2
The profitability index (PI) is the present
value of future cash flows divided by the
initial cost.
FORMULA:
ProfitabilityIndex=1+NetPresentValue/
InitialInvestment
ProfitabilityIndex=(NetPresentValue+
InitialInvestment/InitialInvestment)
ProfitabilityIndex=(Presentvaluefuture
cashfllows/InitialInvestment)
OR
ProfitabilityIndex=(Presentvalueinflows/
presentvalueoutflow)

3. Example-1 of PI?
3
Example:anengineeringfirminvested$20,000fora
projectandexpectedNPVofthatprojectis$5,000.
Solution:
Weknowthat
Profitability Index= (20,000 + 5,000) / 20,000
= 1.25…Answer(confirm?)
Results:Thatmeansacompanyshouldperform
theinvestmentprojectbecauseprofitabilityindexisgreater
than1.

4. Example-2 of PI
4
Engineering company has $100
million available for investment in the
following potential investment
opportunities. Rank the projects
based on profitability and identify the
projects that should be accepted
keeping in view the company’s
capital budget constraints.
Solution:
Profitability Index = 1 + Net Present
Value/ Initial Investment
Project NPV
Initial
Investment
A
$5
million
$15 million
B
$15
million
$50 million
C
$10
million
$10 million
D
$20
million
$60 million
E
$12
million
$35 million

5. Continue
5
Let’sfirstfindprofitability
indicesofeachproject:
Therankingbasedon
profitabilityindexis:
ProjectC,ProjectE,
ProjectAandDand
ProjectB.Now,Engineers
needtomaximizetotal
netpresentvaluethatcan
beachievedusing$100
millioninvestmentby
applyingtheconceptof
capitalrationingcapital
rationing.
Project Profitability Index
A 1 + 5/15= 1.33
B 1 + 15/50= 1.30
C 1 + 10/10= 2.00
D 1 + 20/60= 1.33
E 1 + 12/35= 1.34

6. Example-3 of PI?
6
AnengineeringfirmEnterprisehasdecidedtoinvestina
projectforwhichtheinitialinvestmentwouldbe$100
million.Asitisconsideringwhetherit’sagooddealto
investin,ithasfoundoutthatthepresentvalueofthe
futurecashflowofthisprojectis130million.Isitagood
projecttoinvestininthefirstplace?CalculateProfitability
Indextoprovethat.
Solution:
PI = Present Value of Future Cash Flow / Initial Investment
PI = US $130 million / US $100 million
PI = 1.3…Answer (confirm?)

7. Example-4 of PI?
7
Let’ssaythatengineeringcompanyinvestsinanew
project.TheirinitialinvestmentisUS$10000.
Conditionrequired:
EngineersneedtocalculatetheProfitabilityIndexandfind
outwhetherthisprojectisworthyoftheirinvestmentornot.
So,theycanfindoutthepresentvalueoffuturecashflows
intwoways.Firstly,theycancomputebyaddingupallthe
presentvaluesoffuturecashflowsandsecondly,the
relativelyeasierwayistofindoutthediscountedcashflow
eachyear.So,theengineerswilltakethesecond
approachandaddanothercolumntotheabovestatement,
andthatwouldbeofdiscountedcashflows

8. continue
8
SOLUTION
Now,engineersmaywonderhowthey
gotthesefiguresunderthehead
discountedcashflows.Theysimply
tookseparatepresentvaluesoffuture
cashflows.Forexample,inthefirst
year,thefuturecashflowis$4000,
thecostofcapitalis10%andthe
numberoftheyearis1.Sothe
calculationwouldbelikethis–
PV=FV/(1+i)^1
PV=4000/(1+0.1)^1
PV=4000/1.1
PV=3636.36….Answer(confirm?)
ABC COMPANY
Year Cash flow (US $)Discounted
Cash flow
(US $)
0 -10,000 -
1 4000 3636.36
2 4000 3305.78
3 4000 3005.26
4 2000 1366.02
5 2000 1241.84
Total (PV of cash flows)12555.26

9. continue
9
Wefoundoutalloftheabove-discountedcashflowsby
usingthesamemethod.Onlythecostofcapitalchanged
duetotheincreaseinthenumberofyears.
WeknowthatPIformula:
PIFormula=PVofFutureCashFlows/InitialInvestment
Herewehave:
PVofcashflows:$12555.26
Initialinvestment:$10,000
PI=12555.26/10,000
= 1.26….Answer (confirm?)
Result: PI is greater than 1 it means project is accepted.

10. Example-5 of PI?
10
Let’stakenanexampletounderstandhow
profitabilityindexiscalculated.Assumethat
acompanyinvests$5,000inaproject,
whichgeneratesthefollowingcashflowin
thenext5years.Thefirmhasacostof
capitalof10%.Column3presentsthe
discountedcashflows.
Solution:
Initial Investment = $5000
PI = 6277.64/5000
= 1.25….. Answer(confirm?)
Result:
SincePI>1,theprojectcanbeaccepted.
Year Cash FlowDiscounte
d Cash
Flows
0 -5000
1 2000 1818.18
2 2,000.001652.89
3 2,000.001502.63
4 1,000.00683.01
5 1,000.00620.92
Total (PV of cash
flows)
6277.64

11. 11
NET PRESENT VALUE (NPV)

12. Net Present value (NPV)
12
NPVisthedifferencebetweenthe
presentvalueofcashinflowsand
thepresentvalueofcashoutflows
overaperiodoftime.(NPV=
PVinflows-PVoutflows)
Itisanindicatorofhowmuch
valueaninvestmentorproject
addstothefirm.
Italsomeasurestheexcessor
shortfallofcashflows,inpresent
valueterms,oncefinancing
chargesaremet.

13. Measurement of Net Present Value
(NPV)
NPV = + + ···+ −Initial cost
CF
1
CF
2 CF
N
(1 + r )
1
(1 + r)
N(1 + r)
2
13

14. Acceptance Rules of NPV
14
If answer is +ve, so project is accepted.
If answer is -ve, so project is rejected.
If answer is zero, so project is on
breakeven/ no profit no loss.
Managers increase shareholders’ wealth by
accepting all projects that are worth more
than they cost.
Therefore, they should accept all projects
with a positive net present value

15. Net Present Value?
15
Significance of NPV
Advantages of NPV
Disadvantages of NPV

16. Example-1 of NPV?
Suppose that project A cost $ 2,500 now and is
expected to generate year-end cash inflows of
$ 900, 800, 700, 600 and 500 in year 1 through
5 respectively. The discount rate may be
assumed to be 10 %.
Solution:
NPV= 900/ (1+0.10)^1 + 800/ (1+0.10)^2 + 700/ (1+0.10)^3
+ 600/ (1+0.10)^4 + 500/ (1+0.10)^5 –2,500
= $ 225……..Answer ….(confirm?)
So project is ?

17. Example-2 of NPV?
17
Ifthecostofanyprojectis=-$200,000andthe
Marketvalue(Presentvaluefuturecashflow)
=$201,036
Solution
The difference between the market value and its
cost = value added.
NPV = 201,036 –200,000
= $ 1,036….Answer (confirm?)

18. Example-3 of NPV?
18
SupposeCompanyAiscomparingtwoprojectstoinvest
in.Thediscountrateforbothprojectsis10%.
Solution:forProject1:
Initialinvestment:$10,000,Discountrate:10%
Year 1: $5,000
Year 2: $15,000
Year 3: $9,000
Year 4: $18,000

19. Continue
19
Let’scalculatethepresentvaluesforeachyearoftheproject:
Year1:5,000/(1+.10)^1=$4,545
Year2:15,000/(1+.10)^2=$12,397
Year3:9,000/(1+.10)^3=$6,762
Year4:18,000/(1+.10)^4=$12,294
soweknowthat
NPV = PVinflows -PVoutflows
NPV = ($4,545 + $12,397 + $6,762 + $12,294) -$10,000
NPV = $25,998…..project-1(confirm?)

20. Continue
20
Project2
Initialinvestment:$5,000,Discountrate:10%
Year1:$8,000,Year2:$16,000
socalculatethepresentvaluesforeachyearoftheproject-2:
Year1:8,000/(1+.10)^1=$7,273
Year2:16,000/(1+.10)^2=$13,223
Weknowthat
NPV = PVinflows-PVoutflows
NPV = ($7,273 + $13,223) -$5,000
NPV = $15,496…….project-2 (confirm?)
Result:
The NPV for Project 1 is $25,998 which is higher than the NPV of Project 2
which is $15,496. Company A would definitely invest in project-1 (confirm?)

21. Example-4 of NPV?
21
Youhavetheopportunitytopurchaseanofficebuilding.Youhavea
tenantlinedupthatwillgenerate$16,000peryearincashflowsfor
threeyears.Attheendofthreeyearsyouanticipatesellingthe
buildingfor$450,000.Ifthebuildingisbeingofferedforsaleata
priceof$350,000,wouldyoubuythebuilding?
Discountrate:7%
Solution
NPV= 16000/ (1.07)^1 + 16000/ (1.07)^2 + 466,000/ (1.07)^3 –
350,000
= $ 59,323….Answer (confirm?)
So, project would be accepted.

22. Example-5 of NPV?
22
Supposeacompanyisplanningtoinvest$9,000ina
projecttoday.Theprojectisexpectedtohavealifeof4
years.Theexpectedcashflowsattheendofeachofthe
next4yearsare$2000,3000,3000and4000.The
discountrateis10%.
Solution
NPV = 2000/ (1.1)^1 + 3000/ (1.1)^2 + 3000/ (1.1)^3 +
4000/ (1.1)^4 –9000
NPV = $ 283.51…Answer (confirm?)
Project is accepted

23. Example-6 of NPV?
23
Solve the example
Discount rate:20%
Year 0 1 2 3 4 5
Cash flow -1000 120 280 360 600 800
NPV:$113.63….Answer (confirm?)

24. Conclusion
24
TheRoleoffinanceprofessionalsarechanging.Thereis
anexpectationforfinanceorganisationstotakeona
broaderroleintermsofprovidingmanagement
informationandanalysisandbecomemoreinfluentialin
howtheorganisationismanaged.Inforward-looking
organisations,financeisevolvingfromafocuson
transactionsandcostefficiencytoabroaderfocusthat
coversdecisionsupportandstrategy.Howfinancetakes
onthisbroaderroleinservingthebusinessinthefuture
hasimplicationsforthetypesofskillsneededandthe
developmentofthoseskills.

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