Answer

(a) Net Present Value (NPV)

Net present value is a tool use to analyze the profitability of a project or investment in Capital
budgeting. It is calculated or derived by taking the difference between the present value of cash inflows
and present value of cash outflows over a period of time. In other words, Net present value (NPV) is a
financial metric that seeks to capture the total value of a potential investment opportunity. The
rationale behind NPV is to project all of the future cash inflows and outflows associated with an
investment, discount all those future cash flows to the present day, and then add them together.

The resulting number after adding all the positive and negative cash flows together is the investment's
NPV. A positive NPV means that, after accounting for the time value of money, individual or company
will make money if they proceed with such investment.

Example: The compound annual return an investor expects to earn over the life of an investment is in
the form of security. If a security offers a series of cash flows with an NPV of $50,000 and an investor
pays exactly $50,000 for it, then the investor's NPV is $0..

(b) Profitability Index

The Profitability Index (PI) measures the ratio between the present value of future cash flows and the
initial investment. The index is a useful tool for ranking investment projects and showing the value
created per unit of investment.

The Profitability Index is also known as the Profit Investment Ratio (PIR) or the Value Investment Ratio
(VIR).

Therefore:

 If the PI is greater than 1, the project generates value and the company may want to proceed
with the project.

 If the PI is less than 1, the project destroys value and the company should not proceed with the
project.

 If the PI is equal to 1, the project breaks even and the company is indifferent between
proceeding and not proceeding with the project.
The higher the profitability index, the more attractive the investment.

Example: Assume a project costs $10,000. It will generate cash flows of $3000, $4000, $5000 for the
next 3 years. Calculate the profitability index if the discount rate is 10%.

Solution: 

Profitability Index = [ CF1 × (1 + r) -1 + CF2 × (1 + r) -2 + . . . + CFn × (1 + r) -n ] / CF0

Year Cash Flow Value

0 -10000
1 3000 2,727.27

2 4000 3,305.78
3 5000 3,756.57

In this example, the profitability index (PI) would be calculated as follows:

Profitability Index = [ 3000/(1.1)1 + 4000/(1.1)2 + 5000/(1.1)3 ] / 10000

= [ 2,727.27 + 3,305.78 + 3,756.57 / 10000

= [ 9,789.62 ] / 10000

= 0.9789

The profitability index for this project is 0.9789 which is near to 1. The company may not proceed with
the investment

c) The accounting rate of return (ARR)

The accounting rate of return (ARR), also called the simple or average rate of return, is an investment
formula used to measure the annual earnings or profit an investment is expected to make. In other
words, it calculates how much money or return you as an investor will make on your investment.

Accounting Rate of Return (ARR) is the average net income an asset is expected to generate divided by
its average capital cost, expressed as an annual percentage. The ARR is a formula used to make capital
budgeting decisions. It is used in situations where companies are deciding on whether or not to invest in
an asset or project even towards an acquisition based on the future net earnings expected compared to
the capital cost.
 ARR = Average Annual Profit / Average Investment

Where:

 Average Annual Profit = Total profit over Investment Period / Number of Years

 Average Investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2

Components of ARR

If the ARR is equal to 5%, this means that the project is expected to earn five cents for every dollar
invested per year.

In terms of decision making, if the ARR is equal to or greater than a company’s required rate of return,
the project is acceptable because the company will earn at least the required rate of return. If the ARR is
less than the required rate of return, the project should be rejected. Therefore, the higher the ARR, the
more profitable the company will become.

Example

XYZ Company is looking to invest in some new machinery to replace its current malfunctioning one. The
new machine, which costs $420,000, would increase annual revenue by $200,000 and annual expenses
by $50,000. The machine is estimated to have a useful life of 12 years and zero salvage value.

Annual Profit

Inflows Year 1 -12

(200,000 x 12) 2,400,000

Less: Expenses
(50,000 x 12) (600,000)

Less: Depreciation (420,000)

Total Profit 1,380,000

Average Annual Profit

(1,380,000 / 12) 115,000

Average Investment

Ave Investment (420,000 = 0) / 2 210,000

 ARR
115,000 / 210,000 54.76 %

Therefore, this means that for every dollar invested, the investment will return a profit of about 54.76
cents.