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148
Business Finance (ACC501)
Lesson 28
Review of the Previous Lecture
•
Net Present Value
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Average Accounting Return
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The Payback Rule
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Internal Rate of Return
Topics under Discussion
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Profitability Index
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Capital Budgeting Practice
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Making Capital Investment Decisions
–
Project Cash Flows
Profitability Index
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Also defined as benefit cost ratio, this index is defined as the present value of the
future cash flows divided by the initial investment.
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So if a project cost $200 and the present value of its future cash flows is $220, then
the profitability index would be
PI = $220 /200 = 1.10
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Also, the NPV for this investment is $20, so this a desirable investment.
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The profitability index for a positive NPV investment would be bigger than 1.00 and
less than 1.00 for a negative NPV investment
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The PI of 1.10 tells us that per dollar invested, $1.10 in value or $0.10 in NPV results.
So it measures value created per dollar invested.
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It is often proposed as a measure of performance of government or other nonprofit
investments.
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When capital is scarce, it is sensible approach to allocate it to those projects with
highest PI
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Consider an investment which costs $5 and has a $10 present value and an
investment costing $100 with a $150 present value.
•
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 Spring '11
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 Accounting

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