This page covers CPA questions covering profitability index. The profitability index is to rank competing investments projects; The higher the project profitability index, the more desirable the project.
Profitability Index Capital Budgeting
When using the project profitability index to rank competing investments projects, the preference rule is: The higher the project profitability index, the more desirable the project. Applying this rule to the two investments above, investment B should be chosen over investment A.
The project profitability index is an application of the techniques for utilizing constrained resources discussed in an earlier chapter. In this case, the constrained resource is the limited funds available for investment, and the project profitability index is similar to the contribution margin per unit of the constrained resource.
A few details should be clarified with respect to the computation of the project profitability index. The “Investment required” refers to any cash outflows that occur at the beginning of the project, reduced by any salvage value recovered from the sale of old equipment. The “Investment required” also includes any investment in working capital that the project may need.
The result, shown below in equation form, is called the project profitability index.
project profitability index = Net present Value of project/Initial Investment.
Any decision that involves a cash outlay now in order to obtain a future return is a capital budgeting decision. Typical capital budgeting decisions include:
- Cost reduction decisions. Should new equipment be purchased to reduce costs?
- Expansion decisions. Should a new plant, warehouse, or other facility be acquired to increase capacity and sales?
- Equipment selection decisions. Which of several available machines should be purchased?
- Lease or buy decisions. Should new equipment be leased or purchased?
- Equipment replacement decisions. Should old equipment be replaced now or later?
Capital budgeting decisions fall into two broad categories—screening decisions and preference decisions. Screening decisions relate to whether a proposed project is acceptable—whether it passes a preset hurdle. For example, a company may have a policy of accepting projects only if they provide a return of at least 20% on the investment. The required rate of return is the minimum rate of return a project must yield to be acceptable. Preference decisions, by contrast, relate to selecting from among several acceptable alternatives. To illustrate, a company may be considering several different machines to replace an existing machine on the assembly line. The choice of which machine to purchase is a preference decision.
The term capital budgeting is used to describe how managers plan significant investments in projects that have long-term implications such as the purchase of new equipment or the introduction of new products. Most companies have many more potential projects than can actually be funded. Hence, managers must carefully select those projects that promise the greatest future return. How well managers make these capital budgeting decisions is a critical factor in the long-run financial health of the organization. This chapter discusses four methods for making capital budgeting decisions—the payback method, the net present value method, the internal rate of return method, and the simple rate of return method.