Week 4 Forum 1

Week 4, Forum 1
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Week 4, Forum 1
Net present value (NPV) and profitability index (PI) are two financial accounting tools used to evaluate decisions regarding capital investment. In fact, they are used to make decisions concerning whether or not to accept or reject an investment since they are both measures of how an investment is likely to behave in the future with emphasis being on its anticipated cash flow. It is important to note that the similarity between NPV and PI stop at their capacity to present the future cash flow of an investment. That is because the NPV offers the currency difference for the investment such that a positive value is acceptable while the PI offers the ratio such that a value any value greater than one acceptable. It is additionally important to note that a positive NPV is matched by a PI value that is greater than one thereby resulting in an identical decision on whether to reject or accept the investment. This rule does not hold true for mutually exclusive situations where the investment scales differ such that a positive NPV value would still be matched by a PI ratio of less than one. For instance, let us consider a machine investment requiring $1,000. Its calculated present worth to include the earnings is $1,100. In this case, the PI would be a ratio of 1.1 while the NPV would be $100.
One must accept that although NPV and PI are used in making investment decisions, appreciating their differences can aid in easily and speedily comparing the anticipated incomes from the investment.

In addition, one must acknowledge that PI is an absolute figure since it is a ratio of the proportion between the anticipated returns and amount investment. As such, PI is useful in comparing profitability of investments without regard for the amounts involved whereas NPV is concerned with the amounts involved.

Reference
Madura, J. (2014). International Financial Management (12th ed.). Boston, MA: Cengage Learning.