Scribd
Upload
236 views

Ranking Investment Proposals: Learning Objective

The document discusses various methods for ranking investment proposals, including net present value (NPV), internal rate of return (IRR), profitability index (PI), payback period, and accounting rate of return (ARR). It notes that higher values are preferable for NPV, IRR, PI and ARR, while shorter periods are better for payback period. Key terms defined include time value of money and discounted cash flow analysis.

Uploaded by

Pratibha Nagvekar
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
236 views

Ranking Investment Proposals: Learning Objective

The document discusses various methods for ranking investment proposals, including net present value (NPV), internal rate of return (IRR), profitability index (PI), payback period, and accounting rate of return (ARR). It notes that higher values are preferable for NPV, IRR, PI and ARR, while shorter periods are better for payback period. Key terms defined include time value of money and discounted cash flow analysis.

Uploaded by

Pratibha Nagvekar
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 5

Ranking Investment Proposals

Several methods are commonly used to rank investment proposals, including NPV, IRR, PI,
payback period, and ARR.

LEARNING OBJECTIVE

 Analyze investment proposals by ranking them using different methods

KEY POINTS

o The higher the NPV, the more attractive the investment proposal.


o The higher a project's IRR, the more desirable it is to undertake the project.

o As the value of the profitability index increases, so does the financial


attractiveness of the proposed project.
o Shorter payback periods are preferable to longer payback periods.
o The higher the ARR, the more attractive the investment.

TERMS

 time value of money


The time value of money is the value of money, figuring in a given amount of interest earned
over a given amount of time.

 discounted cash flow


In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or
asset using the concepts of the time value of money.
Problem-4 (Preference ranking of investment projects)

The Martin Company is considering the four different investment opportunities.


The selected information about each proposal is given below:

The present value of cash inflows given above have been computed using a 10%
discount rate. The company is unable to accept all available projects because the
funds available for investment are limited.

Required:

1. Compute the profitability index (present value index) for all the projects.
2. Rank the four investment projects according to preference using:
(a) Net present value (NPV).
(b) Profitability index (PI).
(c) Internal rate of return (IRR).
3. Which one is the best approach for Martin Company to rank five
competing projects?

Solution:
(1). Computation of profitability index:

Formula of profitability/present value index is:

Profitability index = Present value of cash inflows/Investment required


Ranking of Investment Projects)
3. The best ranking approach:

The best method of ranking projects depends on the availability of good reinvestment


opportunities. Under internal rate of return (IRR) method, we assume that the funds released
from a project are reinvested in another project yielding the internal rate of return equal to the
previous project. According to IRR, the project 4 is ranked at number one with 19% IRR. It
means any funds released from project 4 must be reinvested in another project yielding an
internal rate of return of at least 19% but It might be difficult to find a project with such a high
IRR.

The profitability index (PI) shows the present value of cash inflow generated by each dollar
invested in a project. It assumes that the funds released from a project are reinvested in another
project with a return equal to the discount rate. In our problem, the discount rate is only 10%.
Generally, the profitability index is considered the most dependable method of ranking
competing projects.

The net present value (NPV) method considers the net present value figure but does not take into
account the amount of investment required for the project. Therefore, this method is not
appropriate for comparing or ranking competing projects that require different amounts of
investment.  For example, project 3 is ranked at number four because of its low net present value
but it is the best option if we see at the present value of net cash inflow generated by each dollar
invested in the project (as shown by the profitability index).

Conclusion: From above discussion, we can conclude that the profitability index is the most
appropriate and dependable method of ranking projects for Martin Company.
Problem-5 (Internal rate of return and net present value
methods)

Net present value method:

Sunlight company needs a machine for its manufacturing process. The cost of the new
machine is $80,700. The expected useful life of the machine is 8 years. At the end of 8-year
period, the machine would have no salvage value. After installation, the machine would
increase cash inflows by $30,000 per year. Sunlight is interested to know the net preset
value of the machine to accept or reject this investment. The minimum required rate of
return of the company is 16% on all capital investments.

Required:

1. Compute net present value of the machine.


2. Is it acceptable to purchase the machine?

Solution:

 (1) Net present value computation:

(2) Purchase decision:

The positive net present value (computed above) indicates that the investment is profitable,
therefore the machine should be purchased.

You might also like