Sample calculation: Internal Rate of Return (IRR), Net Present Value (NPV) and Profitability Index

By | April 16, 2014

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JobInternal Rate of Return (IRR)Net Present Value (NPV)Profitability index (PI)
KCC Pearl

0.43

$5,832,191

2.94

Sea View

0.38

22,046,133

2.47

Mountain View

0.41

15,533,863

2.73

Hill Top

0.43

18,160,696.50

3.07

Bridgetown

0.27

3,805,830.00

1.73

Northern Giant

0.39

22,647,109.50

2.68

*Detail calculation sees appendix 1

 

With the capital budget of $18,000,000, which job should Kingdom choose and give the reason (s) why.

 

With the capital budget of $18,000,000, we can see that Kingdom could select any of these six projects to invest; therefore we consider which measurement should be used, Net Present Value (NPV) or Profitability index (PI). Because Net Present Value (NPV) calculates a project’s cash inflows minus the present value of the cost, it shows us the present additional value that a project could create for a company; it could be applied in this case of selecting the best option among the six projects. As a result, with a present value of $ 22,046,133, Kingdom should select the Sea View project.

 

Explain why the profitably index method could not be used if KP’s budget were

$12,000,000 instead. Which properties should KP choose in this case?

 

With only a $12,000,000 budget provided, it is for sure that profitability index could not be used in this selection procedure because it did not adequately consider the resource constrains, and obviously, the recommended option, Sea View could not be used since the company could not even pay for the initial investment. In addition, if the projects are not mutually exclusive, the use of KP will tend to recommend several top KP high ranking small projects which could have a less total NPV than the large investment project.

 

If there is only a $12,000,000 budget provided and also the projects are mutually exclusive, Mountain View should be advised because it not only has the highest NPV among the five investment projects besides the Sea View but also it has higher Profitability index (PI) and Internal Rate of Return (IRR) than Northern Giant option which also has similar NPV.