Project Ranking

Question 1

Describe the equivalent annual annuity approach (EAA) to ranking capital projects.

Answer 1

The EAA ranks projects by calculating the constant annual cash flow generated over its entire life as if it was an annuity. The projects are then ranked based on the present value of those cash flows; the higher the cash flows the higher the ranking.

Question 2

Identify techniques and analysis that can be used to measure and address uncertainty in project evaluation.

Answer 2

1. Probability assignment
2. Risk-adjusted discount rates
3. Time-adjusted discount rates
4. Sensitivity analysis
5. Scenario analysis
6. Simulation
7. Decision tree analysis

Question 3

Described the profitability index (PI; also called cost/benefit ratio or present value index).

Answer 3

It ranks projects by taking into account both the net present value (NPV) of each project and the cost of each project.

Computed as: PI = NPV/Project Cost

Question 4

When using the profitability index (PI), how are projects ranked relative to each other?

Answer 4

The projects are ranked according to the computed profitability index (i.e., NPV/Project Cost) for each project; the higher the PI, the higher the rank of the project.

Question 5

Will the profitability index (PI) and the net-present-value (NPV) approaches (to capital budgeting) result in the same ranking of multiple projects?

Answer 5

No. Since the NPV approach does not explicitly consider the differences in initial cost of one project compared to another project, it does not give the same ranking as the profitability index, which considers both the net present value and the initial cost of the project by getting an NPV per dollar invested.

Question 6

Identify two techniques that are intended to rank capital budgeting projects in terms of desirability.

Answer 6

The profitability index (PI) and the equivalent annuity approach (EAA).