Capital Budgeting Paper 15

Answer (C) is correct. The profitability index is the ratio of the present value of future net cash inflows to the initial cash investment. This variation of the net present value method facilitates comparison of different-sized investments. Were it not for this comparison feature, the profitability index would be no better than the net present value method. Thus, it is the comparison, or ranking, advantage that makes the profitability index different from the other capital budgeting tools.

Answer (D) is correct. As long as there is no capital rationing constraint, all projects with net present values exceeding the hurdle rate should be selected. Also, rejecting projects with negative internal rates of return is a sound investment guideline. Companies prefer projects with shorter payback periods.

Answer (C) is correct. If the firm uses a payback period criterion, both projects should be rejected if their payback periods are longer than the company standard. Since the projects are mutually exclusive, only one can be selected. Selecting the project with the higher net present value is consistent with higher profitability.

Answer (A) is correct. Delaying cash outflows increases a project’s net present value, making it more attractive.

Answer (C) is correct. The net present value of a capital project is derived by subtracting the discounted cash outflows from the discounted cash inflows. The profitability index is the ratio of the same two numbers (inflows to outflows). Thus, they will yield the same decision (if the net present value is positive, the profitability index will be > 1).

Answer (C) is correct. The profitability index is an efficient means for ranking capital projects, but it has limitations when capital is rationed and projects are of different sizes. It is the ratio of the net present value of a project’s cash flows to the net investment. Any project with a profitability index > 1 is expected to be profitable.

Answer (A) is correct. The initial calculation would have been $800,000 times the 12% annuity factor of 3.605, or $2,884,000. Deducting the $2,500,000 cost produced the initial NPV of $384,000. The calculation under Scenario R would involve reducing the annual inflows by 10% to $720,000. Multiplying $720,000 times 3.605 produces a present value of $2,595,600. Scenario S would discount the $800,000 of annual inflows using the 18% annuity factor of 3.127, resulting in a present value of $2,501,600. Scenario T would involve discounting the $800,000 for only 4 years, using the 12% factor of 3.037, which results in a present value of $2,429,600. Thus, Scenario R (present value of $2,595,600) has the least effect, followed by Scenario S ($2,501,600), and then Scenario T ($2,429,600).

Answer (B) is correct. In order to compare the cost of the two alternatives, the PV factors of the lease option must be considered. The PV factor of an annuity due (the first payment is due immediately) at a 6% interest rate with n equal to 5 years is 4.46511. Thus, the cost of the lease option is $303,627 ($68,000 × 4.46511). Purchasing the asset would be more advantageous by $3,627 ($303,627 cost to lease – $300,000 cost to purchase).

Answer (C) is correct. The profitability index can be calculated by dividing the PV of future cash flows by the net investment. In order for this to be greater than 1, the required return must be less than the internal rate of return. If the required rate of return is less than the internal rate of return, this means that the project will be profitable for the company because the return on the project is higher than the company’s required rate.

Answer (D) is correct. The profitability index is a method for ranking projects to ensure that limited resources are placed with the investments that will return the highest NPV. This can be calculated by dividing the NPV of the the future cash flows by the net investment.