Page 111 - DBP5043

PROJECT VALUATION TECHNIQUES

PROFITABILITY INDEX

Profitability index is the ratio obtained when the present value of annual
cash flow after tax divided by the initial investment. PI can be calculated
by the following equation:

PI= Present value of annual cash flow after tax
The initial investment ( )

The selection criteria for a project:

A project will:
Received: PI > 1.0 - ACCEPT Project
Less: PI <1.0 -REJECT Project

INTERNAL RATE OF RETURN (IRR)
Internal rate of return is a most appropriate technique to determine the
actual rate of return for any one project. Although these techniques before
taking the present value of money, but it is only based on the rate of
return required by the company.

IRR was defined as the interest rate (cost of capital) that equates the
present value of annual cash flow with an initial investment or in other
words NPV equal to zero.

Present value of annual after tax cash flow = initial investment

IRR = Present value of annual cash flow after tax = the initial investment
TPV = Io , NPV = 0

The selection criteria for a project:

A project will:
ACCECPTED : IRR > required rate of return
REJECT : IRR <required rate of return

If IRR is equivalent to the cost of capital, the company may take the
decision whether to accept or reject the investment project.