Looking for the answer to the question below related to Financial Management ?
………. is known as Benefit/cost ratio
|A. profitability index
B. pay back period
The Correct Answer Is:
- A. profitability index
The benefit/cost ratio is often referred to as the Profitability Index (PI) in the context of capital budgeting. It is used to assess the attractiveness of an investment project by comparing the present value of benefits (cash inflows) to the present value of costs (cash outflows). Let’s delve into why the answer is correct and why the other options are not:
1. Profitability Index (Correct Answer – A):
The profitability index (PI) is calculated by dividing the present value of cash inflows by the present value of cash outflows. In essence, it represents the benefit-to-cost ratio of an investment project.
A PI greater than 1 indicates that the project is expected to generate more value (benefits) than its initial cost (costs). A PI of 1 implies that the benefits are equal to the costs, making it a break-even point. Therefore, the “benefit/cost ratio” directly relates to the Profitability Index, and that’s why Option A is the correct answer.
2. Payback Period (Option B):
The payback period is the time it takes for a project to recoup its initial investment. It does not calculate a benefit-to-cost ratio directly. While it does provide insight into when the initial investment will be recovered, it doesn’t quantify the benefits and costs in present value terms as the Profitability Index does. Therefore, Option B is not the correct answer for “benefit/cost ratio.”
3. Net Present Value (NPV – Option C):
NPV is a method that considers the time value of money by discounting all future cash flows back to their present value. It calculates the net value generated by an investment project by subtracting the initial cost from the present value of cash inflows. While it provides a measure of project profitability, it doesn’t directly express the benefit-to-cost ratio, making Option C less relevant for this term.
4. Internal Rate of Return (IRR – Option D):
The Internal Rate of Return (IRR) is the discount rate at which the NPV of an investment becomes zero. It is essentially a rate of return, not a direct measure of benefit-to-cost ratio. IRR focuses on the point at which the net present value is zero, without explicitly providing a ratio of benefits to costs. Therefore, Option D is not the correct choice for the term “benefit/cost ratio.”
In summary, the term “benefit/cost ratio” is synonymous with the Profitability Index (PI). The Profitability Index directly measures the ratio of benefits to costs in present value terms, making it an appropriate choice for evaluating the attractiveness of investment projects.
The other options, such as the payback period, Net Present Value (NPV), and Internal Rate of Return (IRR), do not directly capture this ratio and are better suited for other aspects of capital budgeting analysis. Therefore, Option A is the correct answer when discussing the “benefit/cost ratio” in the context of capital budgeting.
- Lower the better applies to method of Capital budgeting
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