Question 2 OR (b)

Profitability index and accounting rate of return

6 marks

Question

Question 2 OR (b) · 6 marks

Explain the following techniques of Capital Budgeting: (3×2)

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Read off the question and its marks

12 minfor 6 marks

(i)–(ii)2 items, each marked on its own: give each its share.
Profitability IndexCash flows year by year in one table, then discount, then a one-line decision.

1234

Steps 1 and 3 opens with the meaning: a one-line definition, the quickest mark in each.

Short on time? Trim steps 1 and 3 evenly rather than skip one: each is capped at its own marks. End with step 4 in a line or two.

Try it first. About 12 minutes for 6 marks. Write it out, then open the solution.

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

(i) The Profitability Index (PI)

Meaning. Also called the benefit-cost ratio, the PI is the ratio of the present value of the cash inflows, at the required rate of return, to the initial cash outflow: PI = present value of cash inflows ÷ present value of cash outflows.
Decision rule. Accept the project if PI > 1, reject it if PI < 1; at PI = 1 it may be accepted. A PI above 1 means a positive NPV. Projects are ranked by PI, highest first.
Merits. Like NPV and IRR it is a conceptually sound method that discounts the cash flows, so it allows for the time value of money; being a ratio, it measures profitability per rupee invested, which helps when funds are limited.
Limitations. It is a variation of the NPV method and needs the same computations, so it depends on estimates of cash flows and of the discount rate; and as a ratio it does not show the absolute gain in wealth.

(ii) The Accounting Rate of Return (ARR)

Meaning. The ARR (average rate of return) expresses the average annual profit after tax and depreciation as a percentage of the investment: ARR = average annual profit ÷ average investment × 100, where average investment = (initial investment + salvage value) ÷ 2. Some firms use the initial investment instead; the same basis must be used for all projects.
Decision rule. Accept a project whose ARR exceeds the minimum rate set by management; rank projects by ARR.
Merits. It uses accounting data that are readily available and considers the profit over the whole life of the project.
Limitations. It ignores the time value of money, uses accounting profit rather than cash flows, and depends on accounting choices such as the depreciation method.

#	Component	Marks
1	PI: meaning, formula and decision rule	2
2	PI: merits and limitations	1
3	ARR: meaning, formula and decision rule	2
4	ARR: merits and limitations	1
	Total	6

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