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Unit 5 Financing Decisions: Principles of Finance FA32044/FA36044

This document summarizes key concepts related to financing decisions, including capital budgeting techniques like payback period, accounting rate of return, net present value, internal rate of return, and profitability index. It provides an example to calculate the profitability index of six investment projects and rank them to select the best projects given a limited capital budget of RM10,000,000. The profitability index allows ranking projects based on their net present value as a percentage of initial investment to identify the most profitable uses of available funds.

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ZIKIE CHOY
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Download as PDF, TXT or read online on Scribd
20 views

Unit 5 Financing Decisions: Principles of Finance FA32044/FA36044

This document summarizes key concepts related to financing decisions, including capital budgeting techniques like payback period, accounting rate of return, net present value, internal rate of return, and profitability index. It provides an example to calculate the profitability index of six investment projects and rank them to select the best projects given a limited capital budget of RM10,000,000. The profitability index allows ranking projects based on their net present value as a percentage of initial investment to identify the most profitable uses of available funds.

Uploaded by

ZIKIE CHOY
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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UNIT 5

FINANCING DECISIONS
PRINCIPLES OF FINANCE
FA32044/FA36044
FBBZ/FIA

1
TOPICS COVERED:
T17
• Financing Concepts
T18
• Capital Budgeting
T19
• Payback Period Methods
• Accounting Rate of Return (ARR) Methods
T20
• Net Present Value Method (NPV)
• Internal Rate of Return (IRR)
T21
• Profitability Index (PI)
T22
• Investment Appraisal Decision Making 2
T21 – Profitability Index (PI)

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Introduction: PI
⚫ Most businesses only have a limited amount of capital
available to invest.
⚫ It is therefore necessary to select the best investments,
rather than simply accepting all investments which
have a positive NPV, or an IRR which is higher than
the cost of capital.
⚫ When the supply of capital is limited, managers need
to be able to rank investment projects in their order of
profitability to make the best use of the available
capital.
4
Introduction: PI
⚫ It is easy for managers to rank projects
based on their IRRs, but the IRRs of
projects can be misleading.
⚫ The solution is to use a ranking method
called the ‘Profitability Index’ which is
based on the NPV of projects.

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PROFITABILITY INDEX FORMULA

A project’s profitability index is its


NPV as a percentage of the initial
investment 6
Quick Example 1
Project Investment required NPV

A RM1,500,000 RM2,500,000
B RM3,500,000 RM8,000,000
C RM4,000,000 RM3,250,000
D RM2,000,000 RM3,600,000
E RM2,500,000 RM7,500,000
F RM3,000,000 RM1,300,000
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Quick Example 1
⚫ These projects need more capital than the RM10,000,000
that the company has available at present.

Required:
⚫ Calculate the profitability index for each project and
recommend which should be accepted.

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Solution: Quick Example 1
Project Investment NPV Profitability Ranking
required Index
A RM1,500,000 RM2,500,000
B RM3,500,000 RM8,000,000
C RM4,000,000 RM3,250,000
D RM2,000,000 RM3,600,000
E RM2,500,000 RM7,500,000
F RM3,000,000 RM1,300,000

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Recommendation:
Projects Ranking Investment Capital
Selected Required Remaining

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Notes:
Projects _____ will have to be abandoned
or delayed until enough finance is available.

It is not possible to use all the available


finance.

The Board of Directors (BOD) could


consider starting Project ___ if it believes
that this is wise.

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