Net Present Value & Profitability Index

Feb 1-5. 1

● Each class, I will be providing you with literature taken from online sources, such as
https://corporatefinanceinstitute.com/, https://www.investopedia.com/,
https://www.youtube.com/channel/UCERLF-d9989T6Bzei_rQDHg, among many
others. The only purpose of taking excerpts from online articles is to help you to find
examples of literature so that you may understand the subject that we will be
studying in class.

Review Drawing Cash Flows Diagrams and Net Present

Value.
Exercise a:
Draw a cash flow diagram with the following data:

A mechanical device will cost $30,000 when purchased. Maintenance will cost $2000
per year. The device will generate revenues of $6000 per year for 6 years. The salvage
value is $5000.

Exercise b:
A project generates the following cash flows:
● Year 0: - $200,000 (contractors’ fees)
● Year 1: $400,000 (sales)
● Year 2: $500,000 (sales)
● Year 3: $2’000,000 (sales)
Calculate the NPV of the project using a risk discount rate of 10% per year.

https://www.calculatorsoup.com/calculators/financial/net-present-value-calculator.php
https://www.calculatestuff.com/financial/npv-calculator

Answer a:
Answer b:
Year 0 = - $200,000
Year 1 = $400,000 = $363,636
Year 2 = $500,000 = $413,223
Year 3 = $2,000,000 = $1’502,629
NPV = $2’079,489

Net Present Value.

Example 1:
A project requires an initial investment of $225,000 and is expected to generate the following
net cash inflows:

Year 1: $95,000
Year 2: $80,000
Year 3: $60,000
Year 4: $55,000

Required:
Compute net present value of the project if the minimum desired rate of return is 12%.

Solution:
The cash inflow generated by the project is uneven. Therefore, the present value would be
computed for each year separately:

PV0 = - $225,000
PV1 = $95,000 / (1 + 0.12)1 = $84,821
PV2 = $80,000 / (1 + 0.12)2 = $63,775
PV3 = $60,000 / (1 + 0.12)3 = $42,707
PV4 = $55,000 / (1 + 0.12)4 = $34,954

NPV = $1,257

Example 2:
Let’s suppose that a certain company’s Research and Development Department has
designed a project that will require an investment of 150 thousand USD. They estimate that
the project will yield returns of 70 thousand every year for 3 years.
The Finance Department has calculated that the cost of capital is equal to 9%. The
company could either borrow the 150,000 from a bank at an interest rate of 9% or it could
have this amount already and they could invest it in a bank for that interest rate.

The company’s President wants to know if this project presented by the R&D Department
would be profitable. One of the investment decision criteria frequently used is Net Present
Value.

We would have:
NPV = - $150,000 + 70,000 / (1+0.09)1 + $70,000 / (1+0.09)2 + $70,000 / (1+0.09)3
NPV = - $150,000 + 64,220 + 58,917 + 54,052
NPV = + $ 27,190

If the Net Present Value of this operation is positive, then it means that our earnings are
bigger than our payments and we would have a good investment.

If the Net Present Value of this operation is negative, then it would mean that our payments
are bigger than our earnings and we would have a bad investment.

Again, what is Net Present Value (NPV)? Net Present Value is the difference between the
present value of cash inflows and the present value of cash outflows over a period of time.
NPV is used in capital budgeting and investment planning to analyze the profitability of a
projected investment or project.

NPV = TVECF - TVIC

Where:
TVECF = Today’s value of the expected cash flows
TVIC = Today’s value of invested cash
A positive net present value indicates that the projected earnings generated by a project or
investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is
assumed that an investment with a positive NPV will be profitable, and an investment with a
negative NPV will result in a net loss. This concept is the basis for the Net Present Value
Rule which dictates that only investments with positive NPV values should be considered.

Money in the present is worth more than the same amount in the future due to inflation and
to earnings from alternative investments that could be made during the intervening time. In
other words, a dollar earned in the future won’t be worth as much as one earned in the
present.

Net Present Value of Even Flows:

The net cash flows may be even (equal cash flows in different periods). When they are even,
present value can be easily calculated by using the formula for present value of annuity.

1 - (1 + i)-n
NPV = A X ________ - Initial Investment

Calculate the net present value of a project which requires an initial investment of
$243,000 and it is expected to generate a net cash flow of $50,000 each month for 12
months. Assume that the salvage value of the project is zero. The target rate of return is
12% per annum.
Then, we would have:
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% / 12 = 1%

Net Present Value:

= $50,000 x (1 - (1 + 1%)-12 / 1% - $243,000
= $50,000 x (1 - (1.01)-12 / 0.01 - $243,000
= $50,000 x (1 - 0.887449) / 0.01 - $243,000
= $50,000 x 0.112551 / 0.01 - $243,000
= $50,000 x 0.112551 - $243,000
= $50,000 x 11.2551 - $243,000
= $562,754 - $243,000
= $319,754

Financial calculator for annuities:

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Example 3 (cash inflow project):

The management of Fine Electronics Company is considering purchasing equipment
to be attached with the main manufacturing machine. The equipment will cost $6,000 and
will increase annual cash inflow by $2,200. The usual life of the equipment is 6 years. After
6 years it will have no salvage value. The management wants a 20% return on all
investments.

Required:
1. Compute net present value of this investment project.
2. Should the equipment be purchased according to NPV analysis?

Solution:
1. Computation of Net Present Value:
Initial cost: $6,000
Life of the project: 6 years
Annual cash inflow: $2,200
Salvage value: 0
Required rate of return: 20%

1 - (1 + i)-n
NPV = A X ________ - Initial Investment

i
NPV = $2,200 x (1 - (1 + 20%)-6 / 20% - $6,000
NPV = $7,317 - $6,000
NPV = 1,317

2. Purchase Decision:
Yes, the equipment should be purchased because the net present value is positive
($1,317). Having a positive net present value means the project promises a rate of return
that is higher than the minimum rate of return required by management (20% in the above
example).
In the above example, the minimum required rate of return is 20%. It means if the
equipment is not purchased and the money is invested elsewhere, the company would be
able to earn 20% return on its investment. The minimum required rate of return (20% in our
example) is used to discount the cash inflow to its present value and is, therefore, also
known as discount rate.
Investments in assets are usually made with the intention to generate revenue or
reduce costs in future. The reduction in cost is considered equivalent to increase in revenues
and should, therefore, be treated as cash inflow in capital budgeting computations.
The net present value method is used not only to evaluate investment projects that
generate cash inflow but also to evaluate investment projects that reduce costs. The
following example illustrates how this capital budgeting method is used to analyze a cost
reduction project:

Example 4 (cost reduction project):

Smart Manufacturing Company is planning to reduce its labor costs by automating a
critical task that is currently performed manually. The automation requires the installation of
a new machine. The cost to purchase and install a new machine is $15,000. The installation
of machine can reduce annual labor cost by $4,200. The life of the machine is 15 years. The
salvage value of the machine after fifteen years will be zero. The required rate of return of
Smart Manufacturing Company is 25%.
Should Smart Manufacturing Company purchase the machine?

Solution:
According to the net present value method, Smart Manufacturing Company should
purchase the machine because the present value of the cost savings is greater than the
present value of the initial cost to purchase and install the machine. The computations are
given below:
Initial cost: $15,000
Life of the project: 15 years
Annual cash inflow: $4,200
Salvage value: 0
Required rate of return: $25%

1 - (1 + i)-n
NPV = A X ________ - Initial Investment

i
NPV = $4,200 x (1 - (1 + 25%)-15 / 25% - $15,000
NPV = $1,209

Example 5:
Let’s suppose that you have 1,000 US Dollars today. A friend of yours wants to borrow
these 1,000 USD promising you that he will pay you 1,050 USD one year later. Is this
operation a good investment or a bad one? It depends. Let’s assume that the bank would
give you an interest rate of 6%. Therefore, we have to calculate the Net Present Value of
these operations.

l----------------------------------------------------------------------------------------l (one year later)

1,000 USD 1,050 USD
Net Value = 50 USD

Net Present Value NPV = - 1,000 (1.06) -0 + 1,050 (1.06) -1

1,050
(1.06)1
NPV = - 1,000 + 990.60 = - 9.40

In simple present value, we would be earning 50 USD in one year. However, in net present
value, we would lose 9.40 USD.

Example 6:
Proposal X and proposal Y require an initial investment of $10,000 and are expected to
generate an equal cash inflow of $20,000 over their life of four years. The net cash inflow for
each year of life of both the proposals is given below:
 Year Proposal X Proposal Y

1 2,000 8,000

2 4,000 6,000

3 6,000 4,000

4 8,000 2,000

Total 20,000 20,000

1. Compute the present value of cash inflows generated by both the proposals
assuming a discount rate of 18%.
2. Which of the two proposals is better if compared using net present value method?

Both the proposals generate uneven cash inflows. The present value of cash inflow of both
the proposals would, therefore, be computed by multiplying the net cash inflow generated in
each individual year by the present value of $1 at given interest rate of 18%. These
calculations are given below:

Year Proposal X Proposal Y Present Present Present

value of $1 value of value of
at 18% cash inflow cash inflow
X Y

1 $2,000 $8,000 0.847 $1,694 $6,776

2 $4,000 $6,000 0.718 $2,872 $4,308

3 $6,000 $4,000 0.609 $3,654 $2,436

4 $8,000 $2,000 0.516 $4,128 $1,032

Total $20,000 $20,000 $12,348 $14,552

Notice that both the investment proposals generate equal cash inflow of $20,000 in a 4-year
period but the present value of proposal Y’s cash inflow is greater than the present value of
proposal X’s cash inflow by $2,204 . The reason is that proposal Y generates most of its
cash inflow in earlier years whereas proposal X generates most of its cash inflow in later
years. It reminds us that the money has a time value.

Comparison of two proposals using net present value (NPV) method:

NPV = Initial cost – Present value of cash inflows

● NPV of proposal X: $12,348 - $10,000 = $2,348

● NPV of proposal Y: $14,552 - $10,000 = $4,552

The net present value of both the proposals are positive and therefore both the proposals
are acceptable if evaluated using net present value method. The proposal Y, however,
promises a higher net present value than proposal X and is therefore a better investment to
choose.

Example 7:
A project generates the following cash flows:
● Year 0: - $100,000 (contractors’ fees)
● Year 1: - $200,000 (contractors’ fees)
● Year 2: - $200,000 (contractors’ fees)
● Year 3: $1’000,000 (sales)
Calculate the NPV of the project using a risk discount rate of 20% per year.

● PV0 = - $100,000
● PV1 = - $200,000 / (1 + 0.20)1 = - $166,667
● PV2 = - $200,000 / (1 + 0.20)2 = - $138,889
● PV3 = $1’000,000 / (1 + 0.20)3 = $578,704

NPV = $173,148

Example 8:
Let’s say that you had two potential investment options. Option A allows you to
invest in a shoe manufacturing company that would generate $5,000 annually over the next
5 years. Option B allows you to invest in a grocery store that would generate $3,000 for the
first 3 years and then $8,000 for the last 2 years. If you do the math, both eventually
generate $25,000 over 5 years.

However, based on the net present value of these two investment options, one option
is financially more attractive than the other. Assuming both opportunities are equally risky
and have a discount rate of 10%, find out which is the better option.

Option A Option B

Year 1 $4,545 $5,000 / (1 + 0.1)1 $2,727 $3,000 / (1 + 0.1)1

Year 2 $4,132 $5,000 / (1 + 0.1)2 $2,479 $3,000 / (1 + 0.1)2

Year 3 $3,757 $5,000 / (1 + 0.1)3 $2,254 $3,000 / (1 + 0.1)3

Year 4 $3,415 $5,000 / (1 + 0.1)4 $5,464 $8,000 / (1 + 0.1)4

Year 5 $3,105 $5,000 / (1 + 0.1)5 $4,967 $8,000 / (1 + 0.1)5

$18,954 $17,892

As you can see, even though both investment options generate $25,000 over 5
years, option A results in a higher NPV. In this example, this is largely due to the fact that
you earn higher amounts of cash earlier. Due to the exponential factor in the denominator of
the NPV formula, receiving more cash later vastly reduces distant future cash flows.
Profitability Index
The Profitability Index (PI), alternatively referred to as value investment ratio (VIR) or
profit investment ratio (PIR) or Present Value Index, describes an index that represents the
relationship between the costs and benefits of a proposed project. It is calculated as the
ratio between the Present Value of Future expected cash flows and the initial amount
invested in the project. A higher PI means that a project will be considered more attractive.

Sometimes a company may have limited funds but several alternative proposals. In
such circumstances, if each alternative requires the same amount of investment, the one
with the highest net present value is preferred. But if each proposal requires a different
amount of investment, then proposals are ranked using an index called present value index
(or profitability index). The proposal with the highest present value index is considered the
best. Present value index is computed using the formula:

Present value of cash inflows

Profitability Index = -----------------------------------------------------
Investment required

Since NPV equals the present value of cash flows minus the initial investment, we
can write the present value of future value as the sum of net present value and initial
investment:

Initial Investment + Net Present Value

Profitability Index = ----------------------------------------------------------------
Initial Investment

This gives us another formula for profitability index:

Net Present Value

Profitability Index = 1+ ------------------------------------------
Initial Investment

Example 9:
Choose the most desirable investment proposal from the following alternatives using
profitability index method:

Proposal X Proposal Y Proposal Z

Present value of $212,000 $171,800 $185,200

cash inflows

Investment required ($200,000) ($160,000) ($180,000)

 Net Present Value $12,000 $11,800 $5,200

Solution:
Because each investment proposal requires a different amount of investment, the
most desirable investment can be found using the present value index. Present value index
of all three proposals is computed below:

Proposal X: 212,000/200,000 = 1.06

Proposal Y: 171,800/160,000 = 1.07
Proposal Z: 185,200/180,000 = 1.03

Proposal X has the highest net present value but is not the most desirable
investment. The present value indexes show proposal Y as the most desirable investment
because it promises to generate 1.07 present value for each dollar invested, which is the
highest among three alternatives.

Example 10:
Company F is considering two projects:
Project A requires an initial investment of $1’500,000 to yield estimated annual cash
flows as follows, with a discount rate of 10%.

● Year 1: $150,000
● Year 2: $300,000
● Year 3: $500,000
● Year 4: $200,000
● Year 5: $600,000
● Year 6: $500,000
● Year 7: $100,000

Discounting the Cash Flows of Project A:

● $150,000 / (1.10)1 = $136,363.64
2
● $300,000 / (1.10) = $247,933.88
3
● $500,000 / (1.10) = $375,657.40
● $200,000 / (1.10)4 = $136,602.69
5
● $600,000 / (1.10) = $372,552.79
6
● $500,000 / (1.10) = $282,236.97
● $100,000 / (1.10)7 = $51,315.81

Project B requires an initial investment of $3’000,000 to yield estimated annual cash

flows as follows, with a discount rate of 13%.

● Year 1: $100,000
● Year 2: $500,000
● Year 3: $1’000,000
● Year 4: $1’500,000
● Year 5: $200,000
 ● Year 6: $500,000
● Year 7: $1’000,000

Discounting the Cash Flows of Project B:

● $100,000 / (1.13)1 = $88,495.58
● $500,000 / (1.13)2 = $391,573.34
3
● $1’000,000 / (1.13) = $693,050.16
4
● $1’500,000 / (1.13) = $919,978.09
● $200,000 / (1.13)5 = $108,551.99
6
● $500,000 / (1.13) = $240,159.26
● $1’000,000 / (1.13)7 = $425,060.64

The company F is only able to undertake one project. Using the profitability index
method, which project should the company undertake?

Using the PI formula, Company F should do Project A. Project A creates value

-every $1 invested in the project generates $0.0684 in additional value.

Total PV of Project A = $1’602,663.18

Profitability index of Project A = $1’602,663.18 / $1’500,000
PI = 1.0684
Project A creates value.

Total PV of Project B = $2’866,869.07

Profitability index of Project B = $2’866,869.07 / $3’000,000 = 0.96
PI = 0.96
Project B destroys value.

Example 11:
Your company has $100 million USD available for investment in the following
potential investment opportunities:

Project FV discounted Initial Investment

A $5 million $15 million

B $15 million $50 million

C $10 million $10 million

D $20 million $60 million

E $12 million $35 million

Rank the projects based on profitability and identify the projects that should be
accepted keeping in view the company’s budget constraints.

Let’s first find the profitability indices of each project:

 Project NPV Profitability Index

A 1 + 5 / 15 = 1.33

B 1 + 15 / 50 = 1.30

C 1 + 10 / 10 = 2.00

D 1 + 20 / 60 = 1.33

E 1 + 12 / 35 = 1.34

The ranking based on profitability index is: Project C, Project E, Project A and D, and
Project B.