For the Equivalent Annuity Approach (EAA) Schweser Book 2 Page184: Using the TVM functions of the calculator, the NPV is entered in with a negative sign. Is there any conceptual significance in this ? There is a note saying this is purely for calculation purposes but in calculating the price of the Bond, the negative sign is apt since it is a “CASH OUTFLOW” necessary to RECEIVE the PMTS (+ sign) and the FV (+ sign) SO why the negative NPV ? how do we treat the cash flows as coupons from a bond and live with it ?? Capital Rationing: Schweser Book 2 Page185: Can we use “Profitability Index” (PI) to select the projects PI = 1 + NPV/Cash Outlay and select the projects with the highest PIs ?
I would answer Capital Rationing: PI is a way of analyzing projects’ profitability making them comparable, but it will not show which project is maximizing shareholder value (which is actually the primary decision to make when choosing projects).
When NPV is entered with a -ve Sign (esp to calculate the EAA stuff) - you end up with a positive EAA. If you entered it as a positive number - you would get -ve payments… Yes PI can be used to select projects in a situation of Capital Rationing. First make sure that the Capital Budget constraint has not been exceeded. If two projects have identical NPVs - the PI acts as a tie-breaker.
Thanks for adding to the post. Was confused about usage of PI.
Thank you guys, never really expected such prompt help. Good luck & God bless. PS: @ cpk I almost LoLd , just gotta keep it simple i guess.