If you’re a finance major or an investor, budgeting researcher keen on capital budgeting techniques, then the Net Present Value and Profitability index must have crossed your calculation pads. However, we tend to forget these methods and end up using convoluted notions to see if a project is more profitable than another.
In this article, we will be revising these two methods to provide you with a swift set of tools for your future investments or your comparison of business portfolios. Let’s get started!
What Is Net Present Value (NPV)
In simple terms, NPV is a cash flow technique to determine if a project or investment is optimum for us. To calculate it, we use the following formula:
NPV = CF1/(1+k)^1 + CF2/(1+k)^2 + CF3/(1+k)^3 + CF4/(1+k)^4 + CF5/(1+k)^5 – (Initial Investment)
From the equation above, all the CFs denote the cash flows over a number of years. In total, we have taken five years. The k (sometimes referred to as i) is the discount rate and is mostly known, just like the initial investment value.
Using the above equation, we can find the NPV of a project or an investment in a business. Once done, we can tally the same process for the other investment or project being compared and the higher result would be the project or an investment opportunity we should take. The only case to reject NPV would be a negative value, otherwise, even a return of zero would be deemed suitable for the comparison.
What Is Profitability Index
The reason to mention the profitability index instead of the other two capital budgeting techniques (Payback period, IRR) is its similarity with the NPV method. We will be using the same formula shown above but this time, instead of deducting the sum of cash flows from the initial investment, we will divide it. The result must be at least 1 or more than 1. For reference, the formula would be as follows:
PI = CF1/(1+k)^1 + CF2/(1+k)^2 + CF3/(1+k)^3 + CF4/(1+k)^4 + CF5/(1+k)^5 / (Initial Investment)
How Is NPV Related to PI
Well, if we have a positive NPV, it means the PI would be greater than one as well and vice versa. The PI method does not indicate a cash flow size as the quondam NPV method.
Pros and Cons of NPV
Let’s start with the advantages first:
- Time Value of Money: As NPV is a concept from financial management, it provides us the essence of the time value of money. The results for two projects or investments help us see the sum we are dealing with and its value in the future.
- Decisions Made Easy: The decision-making process is greatly enhanced with this method as we get a blueprint of two companies, projects, or investments and if they will be profitable or provide loss.
- Discount Rate Ambivalence: The k is provided by the companies or the project/investment owners. We know how common window dressing is and this can happen with the discount rate provided, leading to a NPV result that may show ambiguity rather than certainty.
- Only Supports Absolute Values: The method is incompatible with projects of different sizes or dealing with percentages as absolute values are used in this procedure.
- Hidden Costs are Not Considered: All firms, projects, and investments have hidden costs. However, when the method is used, they are not taken as a factor that can greatly affect the profitability of an investment or project.
Pros and Cons of Profitability Index
This time, let’s start with the disadvantages first:
- Too Much Optimism and Possibility of Subjectivity: Because this method is mostly used by researchers, this usually involves estimations and in most cases, the teams conducting these analysis reports are closely linked with the project or investment under study; hence, the chances of subjectivity are naturally increased.
- Opportunity Costs are Mostly Ignored: During the research, most of the agencies are intentionally oblivious to the alternatives if they are complex to calculate. Doing so can provide uncertain results.
- No Sunk Costs: These costs occur before the research starts; therefore, if the research team does not use the previous reports made by the research and development team, the absence of sunk costs can produce understated or overstated figures as a result.
- A Blueprint of Profit or Loss: Many methods used for capital budgeting do not give us a clear picture of the value we bring and the benefits we reap for a certain investment. With PI, we get an overview of our investment in a project and if it will provide the project and its members the desired value they need.
- Future Risks Prognostic: Using this method, we are familiar with the risks that a project might face in the cash flows used for each year. By getting the final costs at the end of each year, we can see the risks for the next year and the steps to take in order to avoid such losses.
- Great for Long-Term Projects: If we have projects to compare for the longer-term, using PI would certainly be productive as it can also provide us information about the future investments a project might need.
Final Thoughts on NPV and PI
From both methods, here are key takeaways:
- NPV is great for the time value of money estimation and daily quick decisions when comparing two similar projects.
- The PI of projects evinces the future investment need for a specific project, helping the investors or decision-makers prepare the contingent steps to counter the losses.
- Both NPV and PI are directly proportional. If a project has a positive NPV result, the PI would be greater than one as well (Project is profitable).
So far, we discussed both methods along with their successes and downfalls. Do keep in mind these methods are great for your daily quick decisions regarding projects that contain yearly cash flows and a discounted rate. Use them next time in your comparison and see if these work out for you. Thank you for reading and all the best for your investing shenanigans!
Author Byline: The writer is a business student and a freelance writer.