That means a company should perform the investment project because profitability index is greater than 1.

Profitability Index Example

Texabonds Inc has decided to consider a project where they predict the annual cash flows to be $5,000, $3,000 and $4,000, respectively for the next three years. At the beginning of the project, the initial investment put into the project is $10,000. Use the Profitability Index Method and a discount rate of 12% to determine if this is a good project to undertake. In order to solve this problem, it is probably a good idea to make a table so that the numbers can be organized by year.

Using a PI table, the following PVIF’s are found respectively for the 3 years: .893, .797, .712. Once the PVIF’s are determined, simply multiply the cash flows and the PVIF’s together in order to get the PV of cash flows for each respective year ($4,465, $2,391, $2,848). Adding up all the PV’s will get the total present value of the project which is $9,704. Divide that final number by the original investment $10,000 and the PI has been determined: .9704. As one can see, the Profitability Index is less than 1 so the project should be scrapped. The NPV can also be determined by subtracting the initial investment ($10,000) from the total PV of the project ($9,704) and you are left with -$296. In this case, because the number is negative, NPV also says that the project should be rejected.

Profitability Index Formula Table

A table for the problem is shown below:

YearCash FlowPVIF at 12%PV of Cash Flow
1$5,000.893$4,465
2 3,000.797 2,391
3 4,000.712 __2,848__

Net Present Value (NPV), defined as the present value of the future net cash flows from an investment project, is one of the main ways to evaluate an investment. Net present value is one of the most used techniques and is a common term in the mind of any experienced business person.

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Net Present Value Method Explanation

Net present value can be explained quite simply, though the process of applying NPV may be considerably more difficult. Net present value analysis eliminates the time element in comparing alternative investments. The NPV method usually provides better decisions than other methods when making capital investments. Consequently, it is the more popular evaluation method of capital budgeting projects.

When choosing between competing investments using the net present value calculation you should select the one with the highest present value.

If: NPV > 0, accept the investment. NPV < 0, reject the investment. NPV = 0, the investment is marginal

Net Present Value Discount Rate

The most critical decision variable in applying the net present value method is the selection of an appropriate discount rate. Typically you should use either the weighted average cost of capital for the company or the rate of return on alternative investments. As a rule the higher the discount rate the lower the net present value with everything else being equal. In addition, you should apply a risk element in establishing the discount rate. Riskier investments should have a higher discount rate than a safe investment. Longer investments should use a higher discount rate than short time projects. Similar to the rates on the yield curve for treasury bills.

Other net present value discount rate factors include: Should you use before tax or after tax discount rates? AS a general rule if you are using before tax net cash flows then use before tax discount rates. After tax net cash flow should use after tax discount rate.

Net Present Value Formula

The Net Present Value Formula for a single investment is: NPV = PV less I

The Net Present Value Formula for multiple investments is: The sum of all terms of: CF (Cashflow)/ (1 + r)^{t}

Where: CF = A one-time cashflow r = the Discount Rate t = the time of the cashflow

Net Present Value Calculation

For a single investment: $120,000 – $5,000 = $115,000

Where: PV = $120,000 I = $5,000 NPV = $115,000

For multiple investments: $120,000 / (1 + 10%)^{1} = $109,091

Where: CF = $120,000 r = 10% t = Year 1 NPV = $109,091

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Net Present Value Advantages

Net present value benefits include: – uses cash flow not earnings – eliminates time component – results in investment decisions that add value

Net Present Value Limitations

Net present value disadvantages include: – difficult to predict cash flows – assumes a constant discount rate over life of investment

Net Present Value Example

Jody is the owner of a debt collections firm called Collectco. Jody has been working on his company for several years. As the years have piled up on Jody so has the urge to retire and live a simpler life. Finally reaching the end of his rope, Jody is ready to move on and spend more time with his children. In order to do this Jody must sell his company. Adding to this, Jody must first make sure his company is up to date with industry standards. If Jody’s company is not performing to the same efficiency as the industry standard he will loose some of it’s value in negotiations with a buyer.

Jody begins by having his company audited by an expert consultant in the industry. The audit turned out to be much better than Jody expected. Despite this, Jody must update his collections software as it is no longer supported by technical assistance from the creator. Jody performs the net present value calculation to evaluate this investment.

$120,000 – $5,000 = $115,000

Where: PV = The yearly income of Collectco = $120,000 I = The cost of the new collections software = $5,000 NPV = $115,000

Now Jody can begin the process of finding a buyer for his company. His consultant, an expert in the business dealings of collections firms, tells him that it is in his best interest to know the Net Present Value of his company before he begins negotiations. Jody starts this process by attempting to find the easiest way to perform this calculation. After finding few relevant online results for the search “net present value calculator”, Jody happens to find the NPV formula. Jody then performs this calculation:

$120,000 / (1 + 10%)^{1} = $109,091

Where: CF = Collectco yearly cashflow = $120,000 r = 10% t = Year 1 NPV = $109,091

With this investment and information Jody can begin to achieve what he has always dreamed of: a comfortable retirement which allows him to spend time with the people he cares about most. Jody is pleased because all of his efforts are resulting in the life he has worked to gain.

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Make-or-buy decisions arise in business when a company must decide whether to produce goods internally or to purchase them externally. This typically is an issue when a company has the ability to manufacture material inputs required for its production operations that are also available for purchase in the marketplace. For example, a computer company may need to decide whether to manufacture circuit boards internally or purchase them from a supplier.

When analyzing a make-or-buy business decision, it is necessary to look at several factors. The analysis must examine thoroughly all of the costs related to manufacturing the product as well as all the costs related to purchasing the product. Such analysis must include quantitative factors and qualitative factors. The analysis must also separate relevant costs from irrelevant costs and look only at the relevant costs. The analysis must also consider the availability of the product and the quality of the product under each of the two scenarios.

The make-or-buy decision involves both quantitative analysis and qualitative analysis. Quantitative considerations can be calculated and compared; qualitative considerations require subjective judgment and often need multiple opinions. Also, some of the factors involved can be quantified with certainty, while other factors must be estimated. The make-or-buy decision requires thorough analysis from all angles.

Quantitative factors to consider may include things such as the availability of production facilities, production capacity, and required resources. They may also include fixed and variable costs that can be determined with certainty or estimated. Similarly, quantitative costs will include the price of the product under consideration as it is being priced by suppliers offering the product in the marketplace for sale.

Qualitative factors to consider require more subjective judgment. Examples of qualitative factors include the reputation and reliability of the suppliers, the long-term outlook regarding production or purchasing the product, and the possibility of changing or altering the decision in the future and the likelihood of changing or reversing the decision at a future date.

Relevant Costs and Irrelevant Costs

When making the make-or-buy decision, it is necessary to distinguish between relevant and irrelevant costs. Relevant cost for making the product are all the costs that could be avoided by not making the product as well as the opportunity cost incurred by using the production facilities to make the product as opposed to the next best alternative usage of the production facilities. Relevant costs for purchasing the product are all the costs associated with buying it from suppliers. Irrelevant costs are the costs that will be incurred regardless of whether the product is manufactured internally or purchased externally.

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Weighted average cost of capital, defined as the overall cost of capital for all funding sources in a company, is used as commonly in private businesses as it is in public businesses.

A company can raise its money from three sources: equity, debt, and preferred stock. The total cost of capital is defined as the weighted average of each of these costs.

Weighted Average Cost of Capital Meaning

Weighted average cost of capital means an expression of the overall requited return on the company’s investment. It is useful for investors to see if projects or investments or purchases are worthwhile to undertake. This is equally as useful to see if the company can afford capital or to indicate which sources of capital will be more or less useful than others. It has also been explained as the minimum return a company can make to repay capital providers.

Weighted Average Cost of Capital Formula

The most popular method to calculate cost of capital is through using the Weighted Average Cost of Capital formula.

WACC = Ke *(E/(D+E+PS)) + Kd*(D/(D+E+PS))*(1-T) + Kps*(PS/(D+E+PS))

Where: Ke = cost of equity Kd = cost of debt Kps= cost of preferred stock E = market value of equity D = market value of debt PS= market value of preferred stock T = tax rate

Ke reflects the riskiness of the equity investment in the company. Kd reflects the default risk of the company, and Kps reflects its intermediate standing in terms of risk between debt and equity. The weights of each of these components reflect their market value proportions and measure how the existing company is financed.

Weighted Average Cost of Capital Calculation

Weighted average cost of capital calculation, though sometimes complex, will yield very useful results.

Example: a company finances its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. The tax rate is 30%. The required rate of return of this company according to the WACC is:

(70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3%

That means the required return on capital is 8.3%. A company pays 8.3% interest for every dollar it finances.

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Weighted Average Cost of Capital Examples

Tim is creating a web 2.0 startup business called Webco. Tim, an avid user of the web and recent college graduate, has quite a bit to learn. He relies off of his networking ability and mentors to receive much needed advice.

Tim has prepared a full business plan. He is now moving his company to the next level by beginning to find capital providers. He has an expected range of the returns each source of available capital will require. Now, Tim needs to use the weighted average cost of capital method to decide whether his company will be able to receive capital from certain providers.

Example Results

After doing some research, Tim is prepared to make his calculation. His results are below:

Tim’s company is considering financing its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. The tax rate is 30%.

That means the required return on capital is 8.3%. A company pays 8.3% interest for every dollar it finances.

Tim’s company, according to his calculations, will not be able to create the returns required to work with the mix of capital which is listed above. He resolves to do more research and come back at the problem with a new approach.

Overall, Tim is satisfied. Though he has not seen the results that he was looking for, he was able to avoid a costly mistake by creating a plan before he began. He has confidence that despite this setback his career has a bright future.

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