Page 135 - DMGT409Basic Financial Management

Basic Financial Management

Notes PVof cashinflows
PI =
Initialcashoutlay
= 54970/50000 = 1.0994

Accept or reject criterion

Accept the project if its profitability index is greater than one. Such a project will have the positive
net present value. Projects can be ranked on the basis of PI. Highest rank will be assigned to the
project with highest PI, while the lowest rank will be given to the project having lowest PI.

Illustration 10: A project requires an investment of `10,000 and the expected cash flows are: 1st
year `12,000; and 2nd year `4,000
The cost of capital is 10 per cent and the PV factors at 10 per cent are 1st year-0.909, 2nd year-
0.826. Compute the profi tability index.

Solution:

Profitability index = Total PV of cash inflows ÷ Initial investment
= (`12,000 × 0.909 + `4,000 X 0.826) ÷ 10,000
= 14,212 ÷ 10,000 = 1.42

It indicates that for every one rupee investment, there is (1.42-1) 0.42 paise profi t.

Case Study RNS Motors Ltd.
NS Adwani, an ITI diploma holder had been working with M/s. RNS and
workshop for the last ten years. He had joined as a technician. He was recognized
Ras the best mechanic of Supreme Garage. A good number of clients preferred to get
their cars repaired by RNS Adwani . In three years time, he was promoted as a supervisor.
RNS Adwani then joined distance education programme of IGNOU and completed his
graduation. He studied accounts and would assist the owner Mr. Gupta in maintaining
the accounts. Mr. Gupta liked him very much and two years back, RNS Adwani was
promoted as the manager of RNS and Workshop.

Gupta had set up this business about 18 years back when he had retired from the Indian
Army due to a leg injury. Due to good customer relations and quality service, RNS and
workshop had earned a very good reputation and was known as the best motor garage in
the district. A large number of clients form the neighbouring district would bring in their
vehicles to Supreme Garage. The workshop was known for engine overhauling. It had
an electrical section for auto electrical and an agency for Exide batteries. RNS specialized
in denting and painting and maintained good relations with insurance companies. It
maintained its own tow truck and did good business during accidents and break-downs.
It presently employed ten full time mechanics, one supervisor besides RNS Adwani and
Gupta who were manager and the owner respectively. During the rush season the workers
worked overtime and additional casual labour was also employed to meet the delivery
schedules.

Contd...

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