ActSc371_Lecture 18_Chapter 7 (Ross) - cont'd part 3

ActSc371_Lecture 18_Chapter 7 (Ross) - cont'd part 3 -...

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Lecture 18 Sections 7.7-7.8: Net Present Value and Other Investment Rules(Corporate Finance by Ross et al.) ActSc 371 – Corporate Finance 1 Instructor: Dr. Lysa Porth 1

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The Profitability Index (PI) The profitability index (PI) is another method that is used to evaluate projects. Profitability index is usually only used to evaluate an investing project. It is calculated by dividing the present value of future cash flows after the initial investment, by the initial investment. Since the initial investment is usually a negative cash flow, the equation uses the absolute value of the initial investment (the positive amount): ( 29 ( 29 0 2 2 1 1 1 . 1 C r C r C r C PI n n + + + + + + =
Example Where r is assumed to be 12%, PI is calculated as follows: Step 1 (PV after initial investment): \$70.5 = \$70/1.12 + \$10/ (1.12)^2 Step 2 (Step 1/initial investment): 3.53 = \$70.5/20 Project C0 C1 C2 1 -20 70 10 2 -10 15 40

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Three possibilities 1. Independent projects: •. NPV criterion says to accept both projects if NPV is positive.
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ActSc371_Lecture 18_Chapter 7 (Ross) - cont'd part 3 -...

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