Log out Go to App
Go to App

Learning Materials

Features

Discover

Chapter 26: Q24RQ (page 1464)

What is the profitability index? When is it used?

Short Answer

Expert verified

Answer

The profitability index aids in classifying investments and selecting the best one to make. A PI value greater than one implies that the investment will generate profits since the present value of expected future cash inflows from the investment is greater than the initial investment.

Step by step solution

01

Use of Profitability index

When a business has a number of potential investments and initiatives, it uses them to compare and contrast them. The index can be used in conjunction with other criteria to decide which investment is the best.

02

Advantages

Through the cost of capital, it considers both the future cash flow risk and the time value of money. When capital is rationed, it helps with ranking and selecting amongst projects.

Unlock Step-by-Step Solutions & Ace Your Exams!

  • Full Textbook Solutions

    Get detailed explanations and key concepts

  • Unlimited Al creation

    Al flashcards, explanations, exams and more...

  • Ads-free access

    To over 500 millions flashcards

  • Money-back guarantee

    We refund you if you fail your exam.

Start your free trial

Over 30 million students worldwide already upgrade their learning with Vaia!

One App. One Place for Learning.

All the tools & learning materials you need for study success - in one app.

Get started for free

Most popular questions from this chapter

Hamilton Company is considering two capital investments. Both investments have an initial cost of \(7,000,000 and total net cash inflows of \)16,000,000 over 10 years. Hamilton requires a 20% rate of return on this type of investment. Expected net cash inflows are as follows:

Year

Plan Alpha

Plan Beta

1

\(1,600,000

\)1,600,000

2

\(1,600,000

2,200,000

3

\)1,600,000

2,800,000

4

\(1,600,000

2,200,000

5

\)1,600,000

1,600,000

6

\(1,600,000

1,500,000

7

\)1,600,000

1,300,000

8

\(1,600,000

1,100,000

9

\)1,600,000

900,000

10

\(1,600,000

800,000

Total

\)16,000,000

\(16,000,000

Requirements

1. Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue?

2. Explain the relationship between NPV and IRR. Based on this relationship and the company’s required rate of return, are your answers as expected in Requirement 1? Why or why not?

3. After further negotiating, the company can now invest with an initial cost of \)6,500,000. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?

Mountain Manufacturing is considering the following capital investment proposals. Mountain’s requirement criteria include a maximum payback period of five years and a required rate of return of 12.5%. Determine if each investment is acceptable or should be rejected (ignore qualitative factors). Rank the acceptable investments in order from most desirable to least desirable

Project

A

B

C

D

E

Payback

3.15 years

4.20 years

2.00 years

3.25 years

5.00 years

NPV

\(10,250

\)42,226

(\(10,874)

\)36,251

$0

IRR

13.0%

14.2%

8.5%

14.0%

12.5%

Profitability index

1.54

1.92

0.75

2.86

1.00

What are some criticisms of the payback method?

How is payback calculated with unequal net cash inflows?

You are planning for a very early retirement. You would like to retire at age 40 and have enough money saved to be able to withdraw \(215,000 per year for the next 40 years (based on family history, you think you will live to age 80). You plan to save by making 10 equal annual installments (from age 30 to age 40) into a fairly risky investment fund that you expect will earn 10% per year. You will leave the money in this fund until it is completely depleted when you are 80 years old.

Requirements

1. How much money must you accumulate by retirement to make your plan work? (Hint:Find the present value of the \)215,000 withdrawals.)

2. How does this amount compare to the total amount you will withdraw from the investment during retirement? How can these numbers be so different?
See all solutions

Recommended explanations on Business Studies Textbooks

Introduction to Business

Read Explanation

Intermediate Accounting

Read Explanation

Business Operations

Read Explanation

Change Management

Read Explanation

Human Resources

Read Explanation

Strategic Direction

Read Explanation
View all explanations

What do you think about this solution?

We value your feedback to improve our textbook solutions.

Study anywhere. Anytime. Across all devices.

Sign-up for free