Page 48 - DMGT521_PROJECT_MANAGEMENT

Unit 3: Strategic Management and Project Selection

5. Profitability Index: Also known as the benefit–cost ratio, the profitability index is the net Notes
present value of all future expected cash flows divided by the initial cash investment.
(Some firms do not discount the cash flows in making this calculation.) If this ratio is
greater than 1.0, the project may be accepted.
6. Other Profitability Models: There are a great many variations of the models just described.
These variations fall into three general categories. These are:
(a) Those that subdivide net cash flow into the elements that comprises the net flow.
(b) Those that include specific terms to introduce risk (or uncertainty, which is treated
as risk) into the evaluation.
(c) Those that extend the analysis to consider effects that the project might have on
other projects or activities in the organization.

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Caution Senior management would like to select a subset of the projects that would most
benefit the firm, but the projects do not seem to be easily comparable.

3.5 Analysis under Certainty

3.5.1 Certainty Assumption

1. Certainty means that although future flows must be forecast or estimated, the estimated
amounts will be received at the times they are expected to occur.

2. Certainty makes the decision simple to model, and the outcome easy to accept.
3. Under the assumption of certainty, future cash flows are to be discounted at a rate which
represents the time value of money.

Example: Project Alpha requires an initial outlay of $900, will have cash inflows of $300
in year 1, $400 in year 2 and $600 in year 3. The discount rate is 8% per annum. The calculation is:
300 400 600
NPV = 900   
(1.08) 1 (1.08) 2 (1.08) 3
= $197.01
This positive result means that, by undertaking the project, the firm’s wealth will increase by
$197.01. Based on the NPV decision rule, the project should be undertaken.
We have made several assumptions in formulating and using this NPV model and decision:
1. the amounts of the initial cash outflow and all future cash flows are known with certainty
2. the discount rate is constant and known with certainty

3. the initial capital outlay occurs at the beginning of year 1 and all operating cash flows
occur at year end
4. cash outflows from the firm are treated as negative; cash inflows are treated as positive

5. there are no constraints on the supply of capital, or on other resources
6. the firm will accept all positive NPV projects.

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