Category Uncategorized

NPV and Profitability Index: Problem and Solution

Firmsconsulting Leave a comment

ABC Corporation plans to invest in project C which have an initial investment of $500,000. ABC’s cost of capital is 8%. The operating cash inflows to be generated from the project will be as follows:

End of 1st year: $100,000

End of 2nd year: $300,000

End of 3rd year: $250,000

1. What is the profitability index for project C?

2. What is NPV for project C?

3. Taking NPV found in previous step into account, is project acceptable according to NPV technique?

4. Based on Profitability Index (PI), is project C is acceptable?

Solution:

1. First we need to find present values of mixed stream of operating cash inflows. We will use financial calculator to do so.

End of 1st year:

FV: $100,000

N: 1

I: 10

Calculate PV: 90,909.09

End of 2nd year:

FV: $300,000

N: 2

I: 10

Calculate PV: 247,933.88

End of 3rd year:

FV: $250,000

N: 3

I: 10

Calculate PV: 187,828.7

Next we need to add up all present values from operating cash inflows to obtain total PV of operating cash inflows:

= 90,909.09 + 247,933.88 + 187,828.7

Total PV of operating cash inflows = 526,671.67

Next we will follow equation for Profitability Index (PI):

PI = Total present value of cash inflows/Initial investment

PI=526,671.67/$500,000

PI=1.05

Therefore, the profitability index (PI) for project C is 1.05.

2. To find NPV, we follow the formula for NPV:

NPV=Present value of cash inflows – Initial investment

Therefore, NPV for project C = $526,671.67 – $500,000

NPV for project C = $26,671.67

3. Since NPV is more than zero ($26,671.67), project C is acceptable according to NPV technique.

4. Since Profitability Index (PI) is greater than 1 (1.05), the project may be considered to be acceptable.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

Sign up to receive a 3-part FREE strategy video training series here.

Sophisticated capital budgeting techniques

Firmsconsulting Leave a comment

Sophisticated capital budgeting techniques include Net present value (NPV), Internal rate of return (IRR), Profitability index (PI) and Equivalent annual annuity (EAA).

Comparing NPV and IRR

Theoretically, it is advisable to use Net Present Value method because NPV assumes that cash inflows are reinvested at cost of capital, which is more realistic than assumption made in Internal Rate of Return method (IRR) that cash inflows reinvested at IRR.

However, in real life, the IRR is more common because it considers the rate of return instead of dollar amount considered in the Net Present Value method and the former seems to be more intuitive to users of techniques. There are, however, ways to deal with shortcomings of IRR and therefore IRR is still can be considered a sophisticated and reliable technique.

 

Capital budgeting and cash flows

Firmsconsulting Leave a comment

To start capital budgeting decision-making process, we firstly need to look at the cash flows of the proposed projects. The cash flows of the project with conventional cash flow pattern may include three components: initial investment, operating cash inflows and terminal cash flow. The first two components are unavoidable and the last component is not always present.

It is also important to note that financing cost is included in the discount rate (required return) and is not included in the cash flows. Financing cost refers to cost of funds that are required for investment in the project.

Further, all cash flows are measured on incremental after-tax basis. Incremental cash flows refer to the additional (marginal) cash flows anticipated from the proposed project. In simple terms, it refers to additional cash flows that occur only if project will be undertaken. For example, if cash inflows prior to commencement of project A were $500,000 and after commencement of project A were $600,000 than incremental cash inflow is $100,000 ($600,000- 500,000). It is calculated as cash inflow with project A minus cash inflow without project A.

Overall, ones initial investment, operating cash inflows and terminal cash flow determined, we can calculate outline of the cash flows from the project as follows:

= Operating cash inflows +/- Terminal cash flow – Initial investment

discounted cash flow

Discounted cash flows

When working with capital budgeting techniques, future cash inflows and outflow are discounted to its present value. This is undertaken for number of reasons. Firstly, according to the time value of money, the dollar to be received in the future has less value than the dollar to be received in the present.

Moreover, adjustment for risk and inflation must also be made. Therefore, compensation is necessary to equalize future and present values of cash flows. Such compensation is known as the required rate of return. The higher is the required return (which is used as a discount rate) the lower will be the present value of the future cash flows from the proposed project.

To ensure that such compensation is in place, the future cash inflows are discounted to its present value with the use of required return. To do so, the following calculation can be made with the help of the financial calculator:

FV: (future cash flow)

N: number of periods between future cash flow and present

I: required return

PV: calculate

Test yourself:

ABC expects to have cash inflows of $5,000 over the next 5 years from the project A. The required return of ABC is 8%. What is the present value of the cash inflows?

Solution:

In this problem we have an annuity, which refers to a terminating an equal periodic cash flows over specific period of time, such as 10 years. Due to the fact that we are dealing with an annuity, we can calculate the present value of all cash inflows much faster and easier than if we were dealing with the mixed stream of cash flows. If we were dealing with the mixed stream, which refers to unequal cash flows during specific period with no precise pattern, than we would have to calculate present value of each cash flow separately and than add them together. We will do such calculation in the next problem. An annuity allows us to calculate present value of all cash flows in one step.

The calculation for this problem is as follows:

PMT: 5,000 (PMT here refers to equivalent cash inflows over period of time)

N: 5

I: 8

PV: calculate = 19,963.55

Test yourself:

ABC also have option to invest in project B. Cash flows from that project will be $3,000 at the end of year 1, $5,000 at the end of year 2, $4,000 at the end of years 3 and 4 and $8,000 at the end of year 5. Calculate the present value of above cash flows if required return of ABC is 8%.

Solution:

As promised, now we are dealing with the mixed stream of cash inflows. We will need to calculate present value of each cash flow separately and than add all present values. With the help of financial calculator, calculation will be as follows:

Cash flow in year 1:

FV: 3,000 (cash inflow at the end of year one)

N: 1

I: 8

PV: calculate 2,777.78

Cash flow in year 2:

FV: 5,000 (cash inflow at the end of year two)

N: 2

I: 8

PV: calculate 4,286.69

Cash flow in year 3:

FV: 4,000 (cash inflow at the end of year three)

N: 3

I: 8

PV: calculate 3,175.33

Cash flow in year 4:

FV: 4,000 (cash inflow at the end of year four)

N: 4

I: 8

PV: calculate 2,940.12

Cash flow in year 5:

FV: 8,000 (cash inflow at the end of year five)

N: 5

I: 8

PV: calculate 5,444.67

Now we will add up all present values to obtain the final answer:

=2,777.78 + 4,286.69 + 3,175.33 + 2,940.12 + 5,444.67

=18,624.59

Therefore, the present value of a mixed stream of cash flows from project B is $18,624.59.

If we look at this a previous problem we can conclude that, assuming that projects A and B require equal investment, project A is a better choice for capital expenditure because it offers a higher present value of future cash inflows ($19,963.55) from investment than does project B ($18,624.59).

Discounted Cash Flows

Firmsconsulting Leave a comment

Management Consulting

Firmsconsulting Leave a comment

Are you interested in joining McKinsey, Bain or the BCG?

Do you need to buy the definitive book to teach you the secrets of the top consulting firms and introduce you to the industry?

Do you want free case interview preparation video tutorials?

Do you need help preparing your résumé and cover letter?

Do you need insightful reviews about management consulting?

Visit our sister site: Firmsconsulting.com

If you need consulting templates and documents visit Lillilooloo.com

Total Asset Turnover

Firmsconsulting Leave a comment

Total asset turnover is one of the activity ratios indicating the relationship between assets and sales (revenue). Activity ratios help businesses to measure how efficiently various accounts are converted into sales or cash. Other activity ratios include average payment period, average collection period and inventory turnover analysis.

It calculates how efficiently assets are used to produce sales or revenue. In other words, how efficiently the balance sheet is managed. It shows how many dollars of revenue is earned per each dollar of assets. It is also referred to as asset turnover or asset turnover ratio.

The formula to calculate the ratio is as follows:

= Sales(Revenue)/Total assets

The health of this ratio is an important factor which contributes to a healthy return on investment (ROI/ROA).

Example of total asset turnover ratio analysis

Assume Heroic Company has sales of $750,000 and total assets of $880,000. The total asset turnover of Heroic Company is calculated as follows:

$750,000 /$880,000=0.85 or 0.9

This indicates that Heroic Company turns over its assets 0.85 (0.9) times per year.

Things to note about total asset turnover ratio

Usually the higher the asset turnover number the more efficiently assets of the business are utilized.

Further, to obtain a better understanding, one should compare the ratio of individual firms to industry averages, to that of leading firms in the industry and to historical results.

Calculating gross profit

Firmsconsulting Leave a comment

Calculating gross profit is simple and straightforward. In summary, we need to subtract cost of goods sold from the sales revenue.

Whilst making this calculation, we need to have a good understanding of the format of the Income Statement, as shown below. More details can be found in the format of the income statement section.

Income Statement Format

Sales revenue

 

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, all we need to do is to subtract cost of goods sold from the sale revenue. But how do we find the cost of goods sold? To calculate the cost of goods sold, we need to take the following steps:

Cost of goods sold =

Opening inventory

ADD: Purchases

LESS: Closing inventory

Gross profit allows us, among other things, to calculate the Gross Profit Margin Ratio , which is:

Gross Profit Margin = Gross Profit / Sales GPMR measures how much of each sales dollar is remaining after costs of goods are deducted. In other words it measures the relative cost of goods sold.

Income Statement Format

Firmsconsulting Leave a comment

Familiarity with the income statement format is important for anyone who wants to succeed in business studies and a business career. You need to be familiar with the format to the point of being able to write down the format from memory.

The income statement, which is also referred to as profit and loss statement (P&L), is one of the most important financial statements. Other important financial statements include the balance sheet, cash flow statement and statement of changes in equity.

A good way to compare the income statement, balance sheet (financial position statement) and cash-flow statement is to think of a river leading to a dam. The income statement and a cash-flow statement record the movement of money over a specific period of time. It is similar to recording the volume flowing down a river over specific period. The balance sheet (financial position statement) is the dam. Everything collects there.

The income statement calculates if the business generated a profit or incurred loss during a specified financial period. In other words, it shows profitability of the organization over a certain period.

If profit was generated during then the bottom line of the statement will be a net profit after taxes, which is also called the net income. The general format is presented below.

General income statement format

Sales revenue

LESS: Cost of goods sold*

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

To calculate Cost of goods sold, one needs to follow the steps:

Opening inventory

Add: Purchases

Less: Closing inventory

= Cost of goods sold

Exam preparation done the right way

Firmsconsulting Leave a comment

Below are some very useful techniques to help you during your exam preparation:

From the core to filling in the gaps

It is always easier to continue with the study module if you already know some of the information. So you have to start from something. It’s okay not to know everything, just build a starting point and work your way out from that point.

Start from learning the most important parts of the study material first. As your body of knowledge grows, continue filling in the gaps. In other words, continue to cover material which is still not clear to you.

One great method to use is possible if you have access to past exam papers. In such cases, start by studying each part that was tested in prior years. As you do that, you will cover most of the critical aspects. Than, cover the gaps in your knowledge.

For too many students exam preparation is an unstructured process. Start by focusing on the main idea first and build your knowledge from there.

Channel your mind chatter

We all have a mind chatter. We are constantly thinking about various things. The majority of such thoughts are useless. During exam preparation it is important to control your mind chatter and to channel it into thinking about your subjects and linking the dots in your study material. Every time your mind chatter resumes, it is taking precious time away from your exam preparation.

Find the ways to channel your mind chatter in a way that is beneficial to your exam preparation. For example, when you doing something that keeps your mind unoccupied and useless mind chatter resumes, start thinking about your material.

Ask yourself which parts of the material are the most important and why. Than ask yourself questions about how different parts of material are connected. Ask yourself what do you understand clearly and what are the biggest gaps in your knowledge. You need to make subjects that you are working on the focus of your mind chatter. This way you take a lemon and make a lemonade out of it.

Give 100% of your effort

When you study, give it 100% of your effort. Read attentively, be focused and use every second you have to do something to improve your knowledge about the subject.

When you study, focus 100% on the task at hand. Be an active learner and not a passive learner. Do something with the material. Be creative. For example, write information down or explain it to yourself in your own words.

Do not allow yourself to become lazy and simply read the material without paying much attention to what you are reading. In this way you are just cheating yourself, no one else. It is your time, your life. As Steve Jobs once said, “you could be doing anything else with your life right now but you have chosen to do this, so give it 100% of your effort… Life is brief and then you die, so you have to be damn good.”

Be self-disciplined

At all times, and especially during exam preparation, you need to be strict with yourself. Demand from yourself to be efficient with the time you have. Do not allow yourself to give in to laziness and weaknesses.

The more you do it – the harder it is to fight giving in. The less you allow yourself to be ineffective and lazy – the easier it is to fight it. As Zig Ziglar likes to say, “If you are hard on yourself, then life will be infinitely easier on you”.

Internalize information

Motivate yourself to absorb and internalize information from each subject you study. It must become part of who you are and what you care about, almost to the point of short-term obsession.

You need to sink into it and build a relationship with it. You need to know it to the point that you can confidently teach someone the knowledge covered in the study material. Only then are you be really prepared.

These points are not a complete list of everything you could do in your exam preparation, but it will put you on the right track to success. Remember, the marks you get will stay on your record for the rest of your life and will likely significantly influence your career  journey.

You are at “war”

If you want your exam preparation to result in A or A + results, you have to take drastic measures. The only exception to this advice applies to people with out of the ordinary intelligence who can gain such results without doing significant amount of work.

To get really high marks, you need to disconnect yourself from all the distraction during exam preparation. Work, work and work, day and night. Your exam material needs to be what you think about when you wake up and when you go to sleep, when you eat and when you taking a shower. And the closer it is to the examination date – the more you need to operate in this manner. Exam preparation must engulf your life.

If you are a straight A student, it sets you apart from other students who are less diligent and driven. When all of you will be applying for the same jobs, who do you think will have a huge advantage over whom? Of course you! Therefore, the first step you need to take to help ensure that you have a great career is to finish your degree as best as you possibly can.

It you already have a degree with average results then consider continuing your education part-time and finish the next level exceptionally well. Academic excellence will always set you apart. It is really hard, especially while working full-time, but it definitely worth it if you want to have a great future.

Good luck with your exam preparation. Give it your 100% and, as Zig Ziglar likes to say, he “will see you at the top”.

Disclaimer

Firmsconsulting Leave a comment

While we have tried our best to create an exciting and factually correct website, it is important to always think any decision through carefully when using information from this website. Any decision about your career development will have a material impact on your finances, future career marketability and, most likely, your happiness. Therefore it is imperative you think through your decisions and actions with the utmost seriousness and apply the diligence we have tried to demonstrate in our articles.

The information contained in this website is for general information purposes only and is subject to change without notice. The information is provided by Blog B School and whilst we endeavour to keep the information up-to-date and correct, we make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability or availability with respect to the website or the information, products, services, or related graphics contained on the website for any purpose. Any reliance you place on such information is therefore strictly at your own risk. In no event will we be liable for any loss or damage including without limitation, indirect or consequential loss or damage, or any loss or damage whatsoever arising from loss of data or profits arising out of, or in connection with, the use of this website.

Through this website you are able to link to other websites which are not under the control of Blog B School. We have no control over the nature, content and availability of those sites. The inclusion of any links does not necessarily imply a recommendation or endorse the views expressed within them.

This website contains material which is owned by or licensed to us, and reproduction of this material is only allowed with our permission. This material includes, but is not limited to, the design, layout, look, appearance and graphics.