Return on Investment

Question 1

Profitability Index (PI)

Answer 1

Profitability index, also known as profit investment ratio and value investment ratio, is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.

Formula: perform NPV calculations for each investment. Then take the net present value and add back the initial investment itself to get the present value.

Then to convert these NPV results to a profitability index, just take the present value and divided by the initial investment.

Question 2

What are the three steps to analysing capital expenditure?

Answer 2

• Step 1: determine the initial cash outlay
  
  • likely to cost before it begins to generate revenue
• Step 2: project future cash flows from investment (you want to know cash inflows not profit)
• Step 3: evaluate the future cash flows - to figure the return on investment
  
  • Three different methods for deciding whether a given expenditure is worth it: Payback Method; Net Present Value; Internal Rate of return (IRR)

Question 3

The Payback Method

Answer 3

• Probably the simplest way to evaluate the future cash flow from a capital expenditure
• It measures the time required for the cash flow from the project to return the original investment
• Formula: take the initial investment of $ and divide by the cash flow per year to get the payback period
• This method doesn’t consider the cash flow beyond breakeven, and it doesn’t give you an overall return; nor does it consider the time value of money ($ today have a different value than $ down the road
• for this reason payback should be used only to compare projects or to reject projects

Question 4

Net Present Value (NPV)

Answer 4

takes into account the time value of money, discounting future cash flows to obtain their value right now; it considers a business’s cost of capital or other hurdle rate; provides an answer in todays $, thus allowing you to compare the initial cash outlay with the present value of the return

• How do you interpret an NPV
  
  • if the NPV of the project is greater than zero, it should be accept, because the return is greater than the company’s hurdle rate
  • higher the interest rates, the higher the opportunity cost for funds
• one drawback on NPV is it can be hard to explain and present to others i.e. based on the discounted value of future cash flows; another drawback, calculations are based on so many estimates and assumptions (cash flow estimates can only be estimated; project sots may be hard to pin down; discount rates can be radically different)

Question 5

Internal Rate of return (IRR)

Answer 5

• rather than assuming a particular discount rate and then inspecting the present value of an investment, IRR calculates the actual return provided by the projected cash flows
• this can then be compared with the company’s hurdle rate to see if it passes the test
• To do this, you can use a financial calculator or a web tool to find the point where NPV equals zero. that is the investment IRR
• IRR is an easy method to explain and present, because it allows for a quick comparison of the projects return to the hurdle rate
• On the downside, it does not quantify the projects contribution to the overall value of the company, as NPV does; also does not quantify the effects of an important variable, namely how long the company expects to enjoy the given rate of return