Video 36 Topic 7 2 4 Profitability Index

Video 36 (Topic 7. 2. 4): Profitability Index (PI) and Payback Period FIN 614: Financial Management Larry Schrenk, Instructor

Topics 1. Profitability Index 1. What is the Profitability Index? 2. Calculating the Profitability Index 3. Analysis of the Profitability Index 2. Payback and Discounted Payback 1. What are the Payback Period and the Discounted Payback Period? 2. Calculating the Payback Period and the Discounted Payback Period 3. Analysis of the Payback Period and the Discounted Payback Period

Profitability Index (PI) The profitability index (PI) is the present value of future cash flows divided by the initial cost. Measures the ‘bang for the buck’

Profitability Index Rule: Do project if PI > 1. 0 PI and NPV Basically same rule: PI > 1 iff NPV > 0 PI (like IRR) cannot be used to compare projects.

PI on Graphing Calculator Consider again these cash flows (r = 10%): Find the PV of the cash flows (CF 0 = 0): npv(interest rate, CF 0, {CF 1, CF 2, …}, {Freq 1, Freq 2, …}) npv(10, 0, {300, 200, 400, 700} and ENTER Answer: $1, 216. 65 Calculate PI Good Project: 1. 22 > 1

Payback Period and Rule Do projects that ‘payback’ the investment within a specific time horizon. Rule: Do project if total cash flow within the payback period > the required investment.

Payback Period Example EXAMPLE: 0 -1, 000 1 300 2 200 3 400 4 700 3 Year Payback Period Calculation 300 + 200 + 400 = 900 < 1, 000 Result: $900. 00 < $1, 000. 00 Bad Project

Calculate Payback Period r = 10% 0 -1, 000 1 300 2 200 3 400 Find payback period: 4 700 300 + 200 + 400 = 900 < 1, 000 < 1, 600 = 900 + 700 Period is between 3 and 4 years Amount left to be paid in year 4 = 1, 000 – 900 = 100 Cash flow in year 4 = 700 Payback point in year 4 = 100/700 = 0. 1429 Payback Period = 3. 1429 years

Discounted Payback Period and Rule Do projects that ‘payback’ in discounted dollars the investment within a specific time horizon. Rule: Do project if present value of the cash flows within the payback period > the required investment.

Discounted Payback Period Example EXAMPLE (r = 10%): 0 -1, 000 1 300 2 200 3 400 4 700 3 Year Discounted Payback Period Calculation: Result: $738. 54 < $1, 000. 00 Bad Project

Calculate Discounted Payback Period r = 10% Cash Flow PV(Cash Flow) 0 1 2 3 4 -1, 000 300 200 400 700 272. 73 165. 29 300. 53 478. 11 Find discounted payback period: 272. 73 + 165. 29 + 300. 53 = 738. 54 < 1, 000 < 1, 216. 65 = 738. 54 + 478. 11 Period is between 3 and 4 years Amount left to be paid in year 4 = 1, 000 – 738. 54 = 261. 46 Discounted cash flow in year 4 = 478. 11 Payback point in year 4 = 261. 46/478. 11 = 0. 5469 Discounted Payback Period = 3. 5469 years

Payback and Discounted Payback: Analysis Strengths: Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Weaknesses: Ignores time value of money (payback) Ignores cash flows after the payback period Time horizon arbitrary

Summary of the Rules NPV: NPV > 0 IRR: IRR > r MIRR: MIRR > r PI: PI > 1 Payback Period*: Payback period cash flow > investment Discounted Payback Period*: Discounted payback period cash flow > investment * Flawed Rule

Video 36 (Topic 7. 2. 4): Profitability Index (PI) and Payback Period FIN 614: Financial Management Larry Schrenk, Instructor