Introduction to Finance

LO 17.6 
The profi tability index is the present value of a project’s cash 
fl ows divided by the project’s initial cost. The present value is com-
puted using the fi rm’s cost of capital. It shows the dollars of benefi t 
from doing a project compared to each dollar of cost. If the PI is 
greater than one, the project is acceptable as it will add to shareholder 
wealth.
LO 17.7 
The payback period is the time it takes for a project to pay 
for itself—that is, for the cash infl ows to equal the cost of the project. 
Shorter paybacks are preferred to longer paybacks. The main drawbacks 

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C H A PT E R 1 7 Capital Budgeting Analysis
to using the payback method are, fi rst, that it ignores the time value 
of money and, second, all cash fl ows after the payback period are 
ignored. The only thing that matters is the length of time it takes for 
the cumulative cash fl ows to equal the project’s cost.
LO 17.8 
All discounted cash fl ow methods of evaluating cap-
ital budgeting projects—NPV, IRR, MIRR, PI—will agree on the 
decision to accept or reject a project. But when mutually exclusive 
projects are under consideration, these methods may rank projects 
diff erently. We learned that some causes of diff erences in ranking 
include diff erent cash fl ow patterns, diff erent time horizons, and dif-
ferent sizes of the projects. Although, in theory, NPV is the best way 
to evaluate projects—it is estimates the dollar impact on shareholder 
wealth—managers may prefer measures that give then an intuitive 
feel for a project’s safety margin, knowing that cash fl ow estimates 
may be incorrect.
LO 17.9 
Estimating cash fl ows is a diffi
cult part of evaluating 
capital budgeting projects. Projected earnings must be converted 
into cash fl ows by using the methods discussed in this chapter. 
Depreciation expense acts as a tax shield because it reduces a 
project’s tax bill and works to increase a project’s after-tax cash 
fl ows. By focusing solely on numbers, fi nancial analysts of cap-
ital budgeting projects can lose sight of the strategic importance 
behind the analysis. On the other hand, strategists need to be aware 
of the need for shareholder value-enhancing projects. Analysts 
must be sure the fi nancial analysis includes the correct base case, 
cannibalization and competitor retaliation eff ects, and proper risk 
adjustments.