The Benefits of Profitability Index

The problems most managers face during investment decisions on multiple investment possibilities, is their ability to make the best and profitability choice under capital constraints. However, when resources are limited, directors can employ profitability index (PI) as a tool for selecting among various project combinations and alternatives. Profitability index enable Directors to identify the relationship between the cost and benefits of a project. A good indicator is a profitability index that is greater than one. Proposals should therefore be ranked according to their profitability index, and top-ranked proposal should be undertaken until the entire funds are used up. For this purpose, we are carrying out an assessment on the five proposals of directors for a profitable order of using up limited funds.

Workings (assessments):

Formula 1.3 PI ratio = present value of cash flows (NPV) / Total initial investment.

Proposal 1(Research and Development)

PI (first phase) = £(-21,201.5/ 50,000) = -42% (not profitable at all) PI (full phase) = £(50,015/ 100,000) = 50%/0.50

Proposal 2(Mainframe Computer System

PI (first phase) = £(50,613/ 90,000) = 56%/0.56 PI (full phase) = £( 70,206/ 180,000) = 39%/0.39

Proposal 3(Extra Warehouse Space)

PI (first phase) = £( 151,720/ 100,000) = 152%/1.52 PI (full phase) = £( 51,720/ 200,000) = 26%/0.26

Proposal 4(Staff Training System)

PI (first phase) = £( 14,088/ 20,000) = 70%/0.70 PI (full phase) = £( 20,656/ 40,000) = 52%/0.52

Proposal 5(Quality Assurance Scheme)

PI (first phase) = £( 114,135/35,000) = 326% /3.26 PI (full phase) = £( 195,370/ 70,000) = 279%

Recommendation - Ranking

Based on the results of our assessment using the profitability indexes on the first phase, Proposal 5 has a PI of 3.26 and proposal 3 has a PI of 1.52. These projects are the profitable proposals that are recommended to be taken. The other three projects have a PI that falls below the acceptable indicator of any number greater than 1. On the other hand, if directors should decide go on board for full phase of the proposals, then only proposal 5 is acceptable with a PI 2.79. Nevertheless, the cost involved in pursuing the two acceptable proposals (£35,000+£100,000) based on phase one and the only acceptable proposal (£70,000) on the full phase will not exhaust the available funds of £300,000. We therefore recommend that on which ever conclusion directors' draw i.e. whether to do full phase or not, they could follow the PI ranks as given on table 1.5 to fully utilise the available funds.

QUESTION 3

Introduction

Investment appraisal is the process of evaluating a project for its economic viability. Many methods of investment appraisal exist - ranging from payback period, NPV, IRR and others. As important as capital budgeting is, investment decisions should not be based purely on financial, but also, other non-financial or qualitative factors that plays significant role in making any meaningful investment decision. These factors include; Government Regulations: Directors must always consider the implications of government actions and inactions on any project they want to execute. This includes relevant laws and regulations such licensing to operate, social and environmental regulations before making investment appraisal. For example, it is likely that proposal 1 and proposal 5 may be subjected to certain government regulations. Competitors' action. There is need for the directors to consider the companies major competitors actions before making investment decisions. Does a market exist already? Are there any fierce competition? Can the product penetrate the market in order to earn estimated inflows? Directors must assess all proposals on this ground to be certain of estimated inflows. Customers' satisfaction: Customers are always the "King", and in order for companies to maximise it objective (that is profit maximisation) it must satisfy it customers. The satisfaction that customers will get from an investment is a non-financial factor to consider before making any investment. In this case, will the proposed investment meet customers' expectation and preferences? Availability of manpower. The company needs to make sure that there are enough people with high skills and expertise to operate the equipment to be invested in. Directors must consider if staffs can handle the changes brought about by the investment, whether they be should be trained to use the new technology. The financial implications of manpower appears to have been considered in proposal 4, however directors must consider all proposals for non-financial purposes. Impact on existing products. Director must consider the repercussions of developing a new product have on existing products. Will product run alongside old products? What happens to existing market for existing products? Will impact be detrimental to existing products or are the company diversifying? Directors are proposal to develop new products in the case of project 1 which may have possible impacts on existing products. Availability of new technology. Recent technologies developed in the area of each proposal must be considered. In addition, directors must assess how technologies in each proposal are frequently changed and how it could impact on the investment proposed. Because if Directors are not able to keep up with competition products may be rendered obsolete and hence unable to meet expected inflows. Probably Directors have considered the financial implications on proposal 4 but again qualitative factors must be considered on all other proposals.

Conclusion

It is very crucial for directors to consider qualitative/non- financial factors of an investment proposal because such factors are more likely to alter the outcome of the decision. To achieve an excellent decision, Directors needs to evaluate their external environment as well as their internal environments (PEST and SWOT analysis) in relation to the proposals and measure how much they could work to the advantage or disadvantage of the company.

QUESTION 4

Introduction

A number of researches have shown that, in practice, the IRR method is more popular than the NPV approach. The IRR is a discount rate that makes the present value of estimated cash flows equal to the initial investment.

Merits and Demerits of IRR

IRR is straightforward and simple. In other words, the IRR method is easy and understandable. Investors with non-financial background can easily appreciate the implications of the IRR on a project. Based on it simplicity, Managers and Investors are able to judge the value of their investment against a companies required rate of return and/or interest rates. It uses cash flows and recognizes the time value of money, like the NPV, which happens to be a step ahead of the ARR and the payback period method, both of which ignore the time value of money. However, IRR method often tends to give unrealistic rates of return. Supposing a company's cost of capital is 10% and the calculated IRR is 40%. It does not mean that directors should immediately accept the project because of the assumption that the company has the opportunity to reinvest future cash flows at 40%. Realistically, it is often impossible for company's to reinvest at rate of 40%. Hence unless the IRR is reasonable, it should not be used as a basis for accepting and rejecting a project. Again, the IRR method may give different rates of return. This makes it difficult for directors to decide on which rate to use or to choose a favorable rate that boost investors' confidence in the project. Regardless of how popular the IRR method is in the business world, it may be a complicated technique to practice.

Merits and Demerits of NPV

NPV take into consideration time value of money because it is based on discounted cash flow, recognized that £1 in the future is worth less than £1 today. Because it considers real cash flows, it is less subject to manipulation and subjective decisions unlike the net profit. For example, net profit is influenced by accounting policies on stock valuation, depreciation and overhead apportionment. Regardless of changes in any of these, the cash flows will remain unchanged. NPV take the cost of raising finance via the discounting process. As shareholders are interested in cash flows and profit maximization, a positive NPV therefore reflects the increase in shareholder wealth that should occur if the project is undertaken. However, in practice it may be difficult to determine the discount rate. This should relate to the cost of finance (or cost of capital, as it is usually known), but calculating the cost that makes up the different elements of finance (e.g. share capital and loans) is difficult. The NPV deals in absolute figures and does not place preference on the size of the project. Supposing there are two mutually exclusive project, NPV would recommend acceptance of a £1 million project with a NPV of £1250 over a £1000 project with a NPV of £500.

Conclusion

Most probably, the IRR method is favoured and widely used in practice because non-financial executives, who include CEOs, Shareholders and board members, can easily relate to percentages and has no difficulty embracing the concept of the project. Nonetheless, NPV tends to be a superior method, because results are valued in amounts thus a positive NPV indicates addition to shareholder's wealth and hence considered as financially worthwhile.

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