Present Value Index

When funds for capital investments are limited, projects can be ranked using apresent value index. A project with a negative net present value will have a present value index below 1.0. Also, it is important to note that a project with the largest net present value may, in fact, return a lower present value per dollar invested.

Let's look at an example of how to determine the present value index.

The company has a project with a 5-year life, an initial investment of $220,000, and is expected to yield annual cash flows of $55,000. Whathat is the present value index of the project if the required rate of return is set at 10%?

present value index = Total present value of net cash flows

Initial investment

Note: Round total present value of net cash flows and initial investment to nearest dollar. Round present value index to two decimal places.

Present value index = $_____________

$220,000 = 0.95

Due to both interest earnings and the fact that money put to good use should generate additional funds above and beyond the original investment, money tomorrow will be worth less than money today.

Simple interest

Ross Co., a company that you regularly do business with, gives you a $10,000 note. The note is due in three years and pays simple interest of 5% annually. How much will Ross pay you at the end of that term? Note: Enter the interest rate as a decimal. (i.e. 15% would be entered as .15)

Principal + ( Principal x Rate x Time) = Total

$10,000 + ( $__________ x 0.05 x 3 ) = 11,500

You may want to own a home one day. If you are 20 years old and plan on buying a $200,000 house when you turn 30, how much will you have to invest today, assuming your investment yields an 8% annual return? $__________

The controller at Ross has determined that the company could save $4,000 per year in engineering costs by purchasing a new machine. The new machine would last 10 years and provide the aforementioned annual monetary benefit throughout its entire life. Assuming the interest rate at which Ross purchases this type of machinery is 10%, what is the maximum amount the company should pay for the machine? $___________