Profitability index is a variation of the net present value method. While NPV provides the absolute total amount for a project, the PI is a relative measure in terms of the ratio of expected return to the initial outlay. Jan (2013) notes that “PI is also sometimes called benefit-cost ratio and is useful in capital rationing since it helps in ranking projects based on their per dollar return.”
- Give reasoned advice to Japan Trading recommending which projects should be selected.
Given that Japan Trading’s available capital for investment is limited to $620K, the proposed projects to pursue are Projects D, F, and E. These projects generate positive NPV and ranks on the top 3 of the six options based on profitability index. Profitability index is used in this capital rationing to ensure that the each project does not only give positive returns, but also the highest returns relative to its required investment.
The total investments on the three (3) projects amount to $510k. This leaves Japan Trading a surplus capital of $110K that may be invested in the money market at a return of 9% per year.
Internal Rate of Return or IRR is another popular method of capital investment appraisal. It calculates the interest yield of the proposed capital project at which the net present value equals zero. The project is accepted if the IRR is greater than the company's required rate of return or rejected if the IRR is less than the hurdle rate (CliffsNotes, nd).
It is commonly used because it is easily understood and simple to apply for comparability of returns on investment projects. It considers the time value of money, and compared to the NPV method, it is an indicator of efficiency (Boundless , nd).
On the other hand, there are also criticisms on the use of IRR technique. For one, IRR cannot be used for exclusive projects or those of different durations such as the projects lined up to Japan’s Trading. IRR may also overstate the rate of return since the inherent formula assumes there are additional projects, with the same positive returns, in which to invest the interim cash flows (Kelleher, J.C. and MacCormack, J.J.,2004).
Works Cited
Boundless (nd). “Advantages of the IRR Method” Available at
https://www.boundless.com/finance/capital-budgeting/internal-rate-of-return/advantages-of-the-irr-method/ (last accessed February 28, 2014)
Cliff Note (nd). “Capital Budgeting Techniques”. Houghton, Mifflin and Harcourt. Available at
http://www.cliffsnotes.com/more-subjects/accounting/accounting-principles-ii/capital-budgeting/capital-budgeting-techniques (last accessed February 28, 2014)
Jan, O. (2013), “Profitability Index.” Available at
http://accountingexplained.com/managerial/capital-budgeting/profitability-index (last accessed February 28, 2014)
Kelleher, J.C. and MacCormack, J.J. (2004), “Internal Rate of Return: A Cautionary Tale”. The
McKinsey Quarterly, McKinsey & Co. Available at http://ww2.cfo.com/strategy/2004/10/internal-rate-of-return-a-cautionary-tale/ (last accessed February 28, 2014)
McGrath, G. (Nov 1998), “Evaluation Techniques for Capital Budgeting.” ACCA. Available at
http://www2.accaglobal.com/archive/sa_oldarticles/39709 (last accessed February 28, 2014)
