- 15 Marks
Question
a. Oyigbo Local Government is set to improve its internally generated revenue by venturing into construction of an animal feedmill, which will cost N15million. The mill, when constructed is projected to generate a net cash inflow of N3.8 million annually and the useful life is 6 years. The cost of borrowing from a commercial bank for this purpose is 12%.
Required: Advise the Chairman of Oyigbo Local Government whether or not to undertake the project using the Profitability Index (PI) technique of investment appraisal.
The cumulative discount factor formula to use is:
where, r = discount rate
n = number of years
(10 Marks)
b. Identify THREE advantages and TWO disadvantages of profitability index as a technique for project appraisal.
(5 Marks)
Answer
a. Investment appraisal under Profitability Index (PI)
Cash outflow = N15,000,000.
Annual cash inflows =N3,800,000 r = discount rate (Cost of borrowing) = 12% n = number of years = 6 years
Cumulative discount factor formular = 1- (1+r)-n r
= 1- (1 + 0.12)-6 0.12
= 4.11
| Years | Cash flow | DF (12%) | Present value |
|---|---|---|---|
| N | N | ||
| 0 | (15,000,000) | 1.0 | (15,000,000) |
| 1 – 6 | 3,800,000 | 4.11 | 15,618,000 |
Profitability Index (PI) = Future cash inflows Cash outflow in year 0
Profitability Index (PI) = 15,618,000 15,000,000
= 1.041
Decision: Based on the above computation, the project should be accepted because the PI is greater than one.
b. Profitability index (PI) Advantages of profitability index (i) It recognises time value of money. (ii) It is a variant of the NPV method. It therefore requires the similar computation as in NPV method. (iii) It is a relative measure of a project‟s profitability since the present value of cash inflows is divided by the present value of cash outflows. (iv) It is generally consistent with the wealth maximisation principle.
Disadvantages of Profitability index (PI)
(i) It can only be used to choose projects under simple, one period, capital constraint situation. (ii) It does not work with mutually exclusive projects as only dependent projects are being considered.
(iii) The technique is not popular in public sector project appraisal.
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