120 Financial Management
a negative net present value) will not be accepted just because it is combined with a
good project (which has a positive net present value ).The limitations of the net present value criteria are:
l The ranking of projects on the net present value dimension is influenced by the
discount rate. To illustrate, consider two mutually exclusive projects - A and B
which have the following cash flow streams :
Year A B
0 -3,00,000 -3,00,000
1 60,000 1,30,000
2 1,00,000 1,00,000
3 1,20,000 80,000
4 1,50,000 60,000The net present value of A and B for various rate of discounts is given below.
Discount rate NPV (A) NPV (B)
10% 36,622 29,180
12 20,390 17,658
14 5,318 6,828
15 -1,826 1,654
16 -8,702 -3,350Looking at the behaviour of net present value, we find that : (i)when the discount
rate is 12 per cent , the net present value of A is greater than the net present value
of B; and (ii) when the discount rate is 14 per cent the net present value of B is
greater than the net present value of A.
l The net present value measure, an absolute measure, does not appear very
meaningful to businessmen who want to think in term of rate of return measures.
Profitability Index (PI)
Profitability Index relates the present value of benefits to the initial investment. It is also
known as Benefit-Cost Ratio (BCR)
PVCF
PI = -------
I
where ,PI = Profitability Index
PVB = present value of cash flows
I = initial investment
To illustrate the calculation of these measures, let us consider a project which is being
evaluated by a firm that has a cost of capital of 12 per cent.