Corporate financeLesson 1 of 2 in the course How Companies Think about Investing

Project Evaluation: Profitability Index, Discounted Payback, and MIRR

5 flashcards · 5 quiz questions · 5 match pairs · 5 fill-in sentences · English

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Summary

The profitability index (PI) is a project evaluation method that expresses a project's present-value benefits relative to its present-value costs. It uses the same cash-flow information as net present value (NPV), but presents the result as a ratio. This lesson explains how to calculate PI, interpret it, and use it in project decisions.

PI=PV of cash inflowsPV of cash outflowsPI = \frac{PV\text{ of cash inflows}}{PV\text{ of cash outflows}}

All flashcards

Discounted payback period
The time needed for discounted cash inflows to recover the initial investment.
Modified internal rate of return (MIRR)
A return measure that discounts outflows and compounds inflows using the firm's cost of capital.
Terminal value in MIRR
The sum of cash inflows compounded to the date of the final inflow.
MIRR reinvestment assumption
Interim cash inflows are reinvested at the firm's cost of capital.
A limitation of MIRR for project ranking
MIRR does not account for differences in project scale.

Quiz questions

  1. How does the discounted payback period measure investment recovery?Answer: It discounts cash flows at the company's cost of funds, then accumulates them until recovery.
  2. What flaw in ordinary payback does discounted payback address?Answer: Ordinary payback ignores the time value of money.
  3. Which limitation applies to the discounted payback method?Answer: It ignores cash flows received after the recovery point.
  4. How are cash inflows handled when calculating MIRR?Answer: They are compounded to the final-inflow date using the firm's cost of capital.
  5. What is one advantage of MIRR over IRR?Answer: MIRR produces a single solution, while some cash-flow patterns give IRR multiple solutions.

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

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