Question

1.) Why might the profitability index be preferable over the NPV method when analyzing capital investments?

2.) "All costs (past, present, future, variable and fixed) are relevant when making a decision between two alternatives”. Is this true or false? Why or why not?

3.) The current ratio assesses a business’s

a. Liquidity b. Profitability c. Market performance d. None of the above

4.) Which of the following is an example of a cost that is variable with respect to the number of units produced?

a. Salaries of top marketing executives b.Rent on the factory building c. Rent on the corporate office building d.Direct materials used in products

Answer 1

1) In real sense profitability index is just an extension of NPV . Profitability indeex give the conclusion in ration form and NPV gives in absolute figures.

Still Profitability index may be given prefence because it provides more wide picture on how much would be the profit or cost saved in terms of investment made.

Since PI gives conclusion in ratio terms , PI of less than 1 means there is loss in project and should not be undertaken. , whereas PI of greater then 1 say 1.2 tells for each $1 invested in project return will be 20% more that is $1.2 in return.

So its give more crisp pcture of the project.

On other hand NPV only tells about its nature positive NPV means project should be accepted and vice-versa. It doesnt tell how much will be the return .

2) Its false , As past costs , Unavoidable fixed cost and future obligated cost are considered sunk or irrelevant and are ignored for decision making process.

Past cost : If research and development has been undertaken for the two alternatives. Then its sunk as whatever alternative you choose research expense is not gonna matter as it has been incurred in past.

Unavoidable fixed cost : Suppose decision is between two product alternatives to produce. In this decision factory rent which is fixed and unavoidable will be considered sunk and will be ignored as it will continue to occur with same amount irrespective of decision.

Future obligated cost : suppose you have contract with labour to pay them ireespective of work for next six months. This becomes future obligated cost. Obligation has been entered today to pay in future. Now in any decison of different alternatives labour cost will be ignored.

3) a) Liquidity as forumula is = current asset / Current liability

It tells how much the current asset are to cover the payment of current liability. Hence its a liquidity ratio that too short term liquidity.

4) d) direct material used in products

As variable cost are defined as cost which varies with the output. direct material direct varies with production . More production demands more material.