Free Custom «Using Expected Values» Essay Paper

It is uncertain. This is because it uses discounted cash flows rather than the real cash-flows of an investment.
It is not appropriate when projects have limited funds.

C (i) Profitability index is the ratio of the present value of future net cash flows to the initial cash outlay of the project. The index provides a relative measure for judging desirability and evaluating the worth of an investment proposal. The profitability index is thus a ratio of the present value of cash inflow at the required rate of return to the initial cash outlay of the investment.

PI= PV of cash inflows/ initial cost outlay

In a period of capital rationing accept a project if the profitability index is greater than 1, otherwise reject I f less than Where there are several projects whose PI is greater than 1, accept the project with greatest PI.

PI for investment X = PV of cash inflows/ initial cost outlay

YEAR  CASHFLOW  PV FACTOR @ 14% PV

1          200                  0.877                          175.4

2          200                  0.769                          153.8

3          150                  0.675                          101.25

4          100                  0.592                          59.2    

5          100                  0.519                          51.9

6          100                  0.455                          45.5

PV                                                                  557.05

COST OUTLAY                                            (200)

NPV                                                               357.05

PI for investment Y = PV of cash inflows/ initial cost outlay

YEAR  CASHFLOW  PV FACTOR @ 14% PV

1          80                    0.877                          70.16

2          80                    0.769                          61.52

3          40                    0.675                          27

4          40                    0.592                          23.68  

5          40                    0.519                          20.76

6          40                    0.455                          18.2

PV                                                                  296.56

COST OUTLAY                                            (100)

NPV                                                               196.26

Thus the PI for X =357.05/200= 1.785          

             PI for Y= 196.26/100 = 1.9626

So you accept project Y because it has a higher PI.

(iii) Limitations of profitability index

Profitability index like other discounting methods uses the discounting factor that is uncertain.

d) Capital purchases are subject to capital deductions’/allowances for tax purposes. This serves to reduce the tax burden on the investor. 

Advantages of IRR.

It considers the time value for money.

It considers all cash flows

It uniformly ranks all rates of return

It focuses on maximum profitability of the shareholders funds

Disadvantages of Internal Rate of Return
it is a complicated method to understand

It makes unrealistic assumptions

It is not a realistic method of comparing mutually exclusive projects

Advantages of AAR

The accounting rate of return is simple to understand

It is also used to appraise projects involving subsidiaries

Disadvantages

It doesn’t consider time value of money

It uses accounting data rather than cash flows hence limiting accuracy of capital projects.

Linda Plc’s investment appraisal method should factor in shareholders wealth. This is best done by use of NPV method. Thus I recommend the company to adopt the NPV method is investment projects appraisal.

Methods used in assessing the risk level of an investment project

These methods include:

Sensitivity analysis

Its also referred to as the “what if analysis”. 

It gives an analysis of the feasibility of a PROJECT BY ANALYSING INDIVIDUAL VARIBALE QUANTITIES.

Break even analysis

This allows an investor to determine the minimum production and sales quantity for each amount in an investment so as to avoid losses.

f) Factors to consider when selecting a source of finance

Cost. The cost of any source of finance is the driving force behind its selection

Availability. A source of finance is selected because it is available

Flexibility

This entails mode of payment, administration and obtaining the source of finance

Taxation

Some source of finance provides at taxable benefit to the company. This included debt capital financing unlike equity and Leasing