Because there is capital rationing, profitability index (PI) will be the best method to apply in deciding which projects the company should undertake. Profitability index will show the return on investment and not just the absolute profit like the Net present Value. But before appraising the proposals using profitability Index, the entire methods used in question one will be used.
Using pay back period method to assess the proposals, proposal 5 would rank 1st because it can pay back the capital invested in one year. 2nd is project 3 which has an outlay of E200, 000 and can repay same in one year and four months. Since there is limited fund available to E 300,000, the AP Plc would only carry out proposals 5 and 3.
Based on the Net present Value (NPV), AP Plc can only carry out proposals 5 and 2. Proposal 5 will give the company a net present value of E195,300, while proposal 2 will give a net present value of E70,140. In total the company will generate a net present value of E263,440. Having discounted the cash flows with the company’s cost of capital of 10%.
Based on profitability index, proposal 5 ranked 1st, proposal 4 ranked 2nd , proposal 1 ranked 3rd , proposal 2 ranked 4th and proposal 3 ranked 5th. Profitability index shows the net present value in relation to the amount invested or initial outlay committed to the project. While Net present value gives the absolute discounted profit, the profitability index relates the profit to the amount invested thereby showing the return on investment. Due to capital rationing, AP Plc only has E300,000 to commit into the projects, therefore only proposals 5, 4 and 1 in that order will be considered appropriate.
IRR is the rate of return that will make the net Present value to be zero, therefore it is the hurdle rate. It is the breakeven rate and it is the minimum cost of capital for the project. Based on IRR, only projects 5 and 3 will be undertaken since the initial outlay of the two proposals totaled E270,300 and the company has only E300,000.
I will recommend the profitability index as it gives the return on investments. Therefore, projects 5, 4, and 1 should be undertaken.
There are other factors that the Directors should consider when making decision apart from the quantitative factors. Some of the other factors are discussed below:
The Directors should consider non – financial benefits that may arise from each proposal like motivation of staff, relationship between the company and suppliers, better quality of the product which may lead to greater market share, improved staff training which will help productivity and reduce labor turnover, and other benefits which may arise.
Cash flows after five years should also be considered greatly because the company is expected to be in existence even after the five years under consideration. Some projects will bring benefit, cash inflows after the five years as well as cost saving while some proposals will only generate cash outflow after five years.
Some proposals will improve the corporate outlook of the company. Outsiders will respect the company thereby bringing better branding to the company. Proposals like research and development, extra ware house, improved information technology, infrastructure like proposal 2 and quality assurance scheme are good example of such proposals. These should be looked into.
Opportunity cost of benefits from proposals not undertaken should also be considered when making decision by the Directors.
Taxation leads to a change in cash flow ,it should be considered when appraising the proposals. Taxation payment reduces cash flow of each proposal. The analyst therefore need to know the amount of tax liability and when due for payment.
Inflation is the increase in average price of goods and services .Attempt should be made to estimate specific inflation for each proposal in order to make a good decision. 4) IRR(Internal Rate of Return) is the true interest rate earned on an investment during its economic life.Its also known as “discount rate of return”.IRR is widely used in practice because it’s the discount rate that gives zero NPV(Net Present Value).IRR relates the size and timing of the cash flow to the initial investment. IRR is the rate compared to the company’s original/set rate. If IRR is greater, than “the opportunity cost of capital”, the investment is profitable and will yield a positive NPV. Moreover , an IRR to be accepted on any project must be greater than or equal to company’s required rate of return unless some other factors dictates its acceptance. IRR calculates the rate of return required to make sure total NPV is equal to the total initial cost. Merits of IRR It places emphasis on liquidity. It put into consideration the time value of money. Its widely used in practice. It helps to get a clear percentage rate of return on investment. An appropriate rate of return does not necessary need to be calculated. NPV(Net Present Value) measures the absolute return on a project. Here the ‘cash inflow’ is compared with the ‘cash outflow’.The difference betweens the two PV is Net Present Value. NPV is another way of determining whether or not a project should be executed.It takes into consideration the time value of money. A project with a positive NPV should accepted (except other factors dictate its acceptance), while a project with a negative NPV be rejected because it does not cover the cost of capital. The positive NPV means the project’s return exceeds the discount rate ,while negative value means the project return is less than the discount rate . The cost of capital is compared with the project rate of return Merits of NPV The time value of money is also taken into consideration. Emphasizes the importance of liquidity by the use of net cash flows. The usage of different accounting policies are not important because they don’t determine the calculation on net cash flows. Its simple to compare NPV of projects and reject project with a negative NPV. It does not require calculating different rates of returns as in IRR. It focuses on Cash flow ,rather than profit and prevents the understatement of returns. A project with a positive NPV increases the wealth of the company. NPV is technically superior to IRR. Its also superior for ranking investment in order of attractiveness.
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