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What Is Investment?
Any act which involves the sacrifice of an
immediate and certain level of consumption in exchange for the expectation of an increase in future consumption.
Traditional Approach
Modern Approach
Payback Period
NPV
IRR
PI
Traditional Approach
Payback Period
Years before full recovery + Uncovered Cost at The Start of The Year Annual Cash Flows during that year
1
2 3
150000
120000 100000
investment.
understand.
flows.
cash flows discounted at the investments cost of capital to recover its cost.
Years before full recovery of discounted annual cash flows + Uncovered Cost at The Start of The Year Cash Flows discounted during that year
1
2
150000
120000
136364
99174
3 100000 75131 Discounted Payback Period:2 years+64462 100000 =2 years 7 months 22 days
Disadvantages:
It ignores cash flows that are paid or
Modern Approach
Net Present Value
Modern Approach
Profitability Index
that discounts all cash flows at the projects cost of capital which are added and then the cost outlay is deducted from that total value.
NPV = present value of cash inflows less present value of cash outflows
to equal zero. A project is accepted if the IRR is greater than the cost of capital.
NPV=49910
NPV=27495
IRR=10%+49910/(49910-27495)(20%10%) =32.266%
investment
reject decisions
projects
Profitability Index
It allows a comparison of the costs and
benefits of different projects to be assessed and thus allow decision making to be carried out.
Profitability Index
Formula:
with limited resources, PI helps to choose the project(s) that gives the highest NPV per dollar of investment.
Profitability Index
Projects A B C D E F -Co -7 -8 -4 -10 -13 -7 PV 11 15 5 6 15 10 NPV +4 +7 +1 +4 +2 +3 PI .57 .87 .25 .40 .15 .42
Profitability Index
The higher the PI, the better it is. So, Project B should be selected as it has the highest PI 0.87. Projects in ascending order
Project B
Project A
Project F
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