BUS202: Principles of Finance

Learning Objectives

1. Evaluate some other methods to evaluating capital budgeting.
2. Calculate Profitability Index.
3. Discuss MIRR.

So far we have learned payback period, NPV and IRR. These three are the most widely used and methods to evaluate capital projects, and are sufficient for most companies, but many other methods exist. Here we'll discuss two other methods: Profitability index and MIRR.

Profitability index (PI) shows the relative profitability of any project: in essence, a ‘bang for your buck' calculation. It is the present value per dollar of initial cost. The higher the profitability index, the better, and any PI greater than 1.0 indicates that the project is acceptable because it adds to corporate value.

Equation 13.3 Profitability Index

$\text{Profitability Index}=\dfrac{\text{Present Value of Future Cash Flows}}{\text{Initial Cost}}$

For Gator Lover's the PI's are as follows:

$\text{Profitability Index Project A}=\dfrac{$58,861.80}{$48,000}=1.22$

$\text{Profitability Index Project B}=\dfrac{$56,567.66}{$52,000}=1.08$

The profitability index is higher for Project A. PI doesn't work as well if the initial investment is spread out over time, or if the cash flows aren't ordinary, which is why we prefer NPV.

Our final method of evaluating capital projects worth discussing is modified internal rate of return (MIRR). IRR is the expected rate of return if the $NPV = 0$. This assumes that early inflows will be reinvested at the return of the project itself! Often, the funds earned from a project cannot be reinvested at IRR, but instead earn a lower rate. Therefore, IRR can overstate the expected rate of return. To compensate for this overstatement, modified internal rate of return (MIRR) was created. MIRR assumes that funds can be reinvested at the weighted average cost of capital (WACC) or some other specifically stated rate.

In our IRR example, we used a hurdle rate of 10%. But what if the inflows could only be reinvested at 8%? To calculate MIRR, we would use the 8%. Lucky for us, spreadsheets have a function to do this quite easily:

=MIRR(cash flows from period 0 to $n$, rate for outflows, reinvestment rate)

Project A MIRR (reinvested at 8%) = 12.89%

Project B MIRR (reinvested at 8%) = 11.63%

Compared with our original IRRs of 12.88% for Project A and 15.43% for Project B, it's easy to see that the reinvestment rate has a large impact. Some shortfalls, however: it's harder to calculate (esp. without technology), and requires knowledge of the WACC. If we have the WACC, however, why not calculate NPV?

So Which Project Wins?

Table 13.3 "Gater Lover's Ice Cream: Summary Chart for Capital Budgeting Decision Making Techniques" a summary chart for the capital budgeting decision making techniques for Gator Lover's Ice Cream's potential projects: Project A and Project B.

Table 13.3 Gater Lover's Ice Cream: Summary Chart for Capital Budgeting Decision Making Techniques

And the winner is…Project A. While Project B has a faster payback period, Project A wins in every other category, especially the critical NPV category. If we can only choose one project, Gator Lover's Ice Cream should open a new store (Project A) instead of investing in a new machine (Project B). Of course, if we can do both, that should be our choice.

Key Takeaways

• Profitability index is bang for your buck.
• MIRR assumes a different reinvestment rate than IRR.

Exercises

1. Calculate PI for Exercises 1 & 2 in Section 13.3 "Net Present Value".
2. Explain how the MIRR would compare to IRR for the projects in Exercises 1 & 2 in Section 13.3 "Net Present Value" if the reinvestment rate is 8%.

 This text was adapted by Saylor Academy under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensor.