Question 2 OR (a)
NPV versus profitability index
4 marks
- Time to write
- About 8 minutes
From an older CBCS paper
Question
Question 2 OR (a) · 4 marksAs methods of evaluating a capital budgeting proposal, compare Net Present Value (NPV) with the Profitability Index (PI). Which one is better, and why ? 4
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- and whyEach answer needs its reason, not just the answer.
- compareCompare in a table, basis by basis.
- Net Present ValueCash flows year by year in one table, then discount, then a one-line decision.
- Which one is betterEnd with a clear choice and the reason for it.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 NPV: meaning and rule 1 mark 2 min
- 2 PI: meaning and rule 1 mark 2 min
- 3 Comparison 1 mark 2 min
- 4 Which is better, and why 1 mark 1 min
Easy marks
- Steps 1 and 2 opens with the meaning: a one-line definition, the quickest mark in each.
Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Net present value (NPV). The present value of the cash inflows, at the required rate of return, less the outlay. A project is accepted if its NPV is positive and rejected if it is negative.
Profitability index (PI). The ratio of the present value of the cash inflows, at the required rate of return, to the initial outlay; accept if PI > 1, reject if PI < 1.
| Point | NPV | PI |
|---|---|---|
| Measure | Absolute (₹ of value added) | Relative (value per rupee invested) |
| Time value of money | Recognised | Recognised |
| Accept–reject decision | NPV > 0 | PI > 1; the two always agree, since a positive NPV means PI > 1 |
| Ranking | Favours projects adding the most value | Favours projects with the highest value per rupee, which may be small ones |
| Limitations | Needs cash-flow and discount-rate estimates | Same estimates; cannot aggregate several small projects to compare with a large one, and cannot be used when the outlay is spread over more than one period |
The PI is a variation of the NPV method and needs the same computations.
Which is better? NPV, for mutually exclusive projects without a shortage of funds: it measures the absolute increase in shareholders' wealth, which is the objective, whereas PI can rank a small project above a larger one that adds more value. PI is useful under capital rationing, where funds are limited and the aim is the most value per rupee.
Where the 4 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | NPV: meaning and rule | 1 |
| 2 | PI: meaning and rule | 1 |
| 3 | Comparison | 1 |
| 4 | Which is better, and why | 1 |
| Total | 4 |
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