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Lecture Investment analysis & portfolio management - Chapter 11

After studying this chapter you will be able to understand: Profitability index, annuities and perpetuity, net terminal value, capital rationing, net terminal value. | Investment Analysis Lecture: 11 Course Code: MBF702 Outline RECAP Profitability index Annuities and perpetuity Net terminal value Capital Rationing Profitability Index Profitability Index Allows a comparison of the costs and benefits of different projects to be assessed and thus allow decision making to be carried out Net Present Value of future net cash flows Profitability Index = --------------------------- ------------------------------- Initial Capital Cost Profitability Index Accept/Reject Decision: if PI > 1, accept the project if PI 1, accept the project if PI < 1, reject the project PI Strengths and Weaknesses Strengths: Same as NPV Allows comparison of different scale projects Weaknesses: Same as NPV Provides only relative profitability Potential Ranking Problems Annuities and Perpetuities Annuity – finite series of equal payments that occur at regular intervals If the first payment occurs at the end of the period, it is called an ordinary annuity If the first payment occurs at the beginning of the period, it is called an annuity due Perpetuity – infinite series of equal payments Perpetuity : PV = CF / r Annuities– Basic Formulas Present value Future value Net terminal value Net Terminal Value is the cash surplus remaining at the end of the project after taking into account repayment of capital / initial cost & return of capital at the required rate. NTV when discounted at the required rate would give the NPV of the project with the underlying assumption that any surplus (arising at the end of each year) would earn interest at the required rate /same rate. Only because of the aforesaid assumption the relationship between NPV & NTV remains true. Capital Rationing A situation in which the company has a limited amount of capital to invest in potential projects such as the different possible investments need to be compared with one another in order to allocate the limited capital available Soft Capital Rationing : Due to internal factors Hard Capital Rationing : Due to external / .