Question

How is the p.i a variation on the net present value concept?

Answer 1

The Net Present Value concept is a variation on the present value concept using interest rates to determine the value of future cash flows.

Step-by-step explanation:

The present value (PV) concept is a financial tool used to determine the current worth of future cash flows by discounting them with a specified interest rate. Net present value (NPV) is a variation of the present value concept that calculates the difference between the present value of cash inflows and the present value of cash outflows. NPV helps in evaluating the profitability and viability of an investment project or business venture. It considers the time value of money and provides a more comprehensive analysis than just considering the present value of cash flows.

The present value (PV) concept is a financial technique employed to assess the current value of future cash flows by discounting them at a predetermined interest rate. Net present value (NPV), a derivative of the present value concept, gauges the disparity between the present value of cash inflows and outflows. NPV proves invaluable for appraising the profitability and feasibility of investment projects or business endeavors. By considering the time value of money, NPV offers a more holistic evaluation than merely assessing the present value of cash flows. A positive NPV signifies that the investment is expected to generate more value than its cost, indicating a potentially sound opportunity. In contrast, a negative NPV suggests that the investment may not yield sufficient returns to justify its costs, aiding decision-makers in making informed choices about capital allocation.

Answer 2

The Profitability Index (PI) is a variation of the Net Present Value (NPV) concept that provides a ratio of payoff to investment, rather than the net dollar amount. While NPV involves summing the discounted future cash flows and then subtracting the initial investment, PI divides the sum of discounted future cash flows by the initial investment to determine how many times the investment is repaid.

Step-by-step explanation:

The Profitability Index (PI) is a variation on the Net Present Value (NPV) concept in that while NPV gives the dollar amount of an investment's worth, the PI provides the ratio of payoff to investment amount, fundamentally acting as a relative measure of an investment's desirability. Both methodologies involve the calculation of present values of future cash flows, discounted back to the present using a particular interest rate, typically referred to as the discount rate. In NPV, the present values of future cash flows are simply totalled and the initial investment is subtracted. In contrast, for PI, the sum of the present values of future cash flows is divided by the initial outlay, granting a value that indicates how many times the investment will be repaid.

When performing present value calculations, the aim is to determine what a future amount is worth now, given a specific interest rate. This involves calculating the present discounted value (PDV) for cash amounts received at various times, and may result in determining a price per share based on total profits and the number of shares outstanding. It's important to note that there is inherent uncertainty in estimating future profits, which can influence the choice of discount rate and thereby affect the NPV or PI.

For example, if the PDV of total profits is $51.3 million, and there are 200 shares, the calculation of PI would involve dividing $51.3 million by the number of shares to get a per-share value. NPV would involve taking into consideration the total investment cost from this amount to determine the net value. Both measures are affected by the expected profits and the chosen discount rate.