Prof.P.S.

Ravindra

UNIT-III
THE INVESTMENT DECISION
INTRODUCTION
The investment decision is the most important one among the three decisions. It relates to the
selection of assets in which funds are invested by the firm. The assets, which can be acquired,
fall into two broad groups:
1. Long-term assets which will yield a return over a period of time in future,
2. Short-term/current assets which are convertible into cash in the normal course of business
usually within a year.
Accordingly, the asset selection decision of a firm is of two types. The first of these involving
the first category of assets is popularly known as capital budgeting. The other one, which refers
to short-term assets, is designated as liquidity decision/Working Capital Management.
TIME VALUE OF MONEY
Money has time value. A rupee today is more valuable than a year hence. It is on this concept
“the time value of money” is based. The recognition of the time value of money and risk is
extremely vital in financial decision making.
Most financial decisions such as the purchase of assets or procurement of funds,
affect the firm’s cash flows in different time periods. For example, if a fixed asset is purchased, it
will require an immediate cash outlay and will generate cash flows during many future periods.
Similarly if the firm borrows funds from a bank or from any other source, it receives cash and
commits an obligation to pay interest and repay principal in future periods. The firm may also
raise funds by issuing equity shares. The firm’s cash balance will increase at the time shares are
issued, but as the firm pays dividends in future, the outflow of cash will occur. Sound decision-
making requires that the cash flows which a firm is expected to give up over period should be
logically comparable. In fact, the absolute cash flows which differ in timing and risk are not
directly comparable. Cash flows become logically comparable when they are appropriately
adjusted for their differences in timing and risk. The recognition of the time value of money and
risk is extremely vital in financial decision-making. If the timing and risk of cash flows is not
considered, the firm may make decisions which may allow it to miss its objective of maximising
the owner’s welfare. The welfare of owners would be maximised when Net Present Value is
created from making a financial decision. It is thus, time value concept which is important for
financial decisions.
Thus, we conclude that time value of money is central to the concept of finance. It recognizes
that the value of money is different at different points of time. Since money can be put to
productive use, its value is different depending upon when it is received or paid. In simpler
terms, the value of a certain amount of money today is more valuable than its value tomorrow. It
is not because of the uncertainty involved with time but purely on account of timing. The
difference in the value of money today and tomorrow is referred as time value of money.
Reasons for Time Value of Money
Money has time value because of the following reasons:
1. Risk and Uncertainty: Future is always uncertain and risky. Outflow of cash is in our control
as payments to parties are made by us. There is no certainty for future cash inflows. Cash
inflows are dependent out on our Creditor, Bank etc. As an individual or firm is not certain about
future cash receipts, it prefers receiving cash now.
2. Inflation: In an inflationary economy, the money received today, has more purchasing power
than the money to be received in future. In other words, a rupee today represents a greater real
purchasing power than a rupee a year hence.
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3. Consumption: Individuals generally prefer current consumption to future consumption.

4. Investment opportunities: An investor can profitably employ a rupee received today, to give
him a higher value to be received tomorrow or after a certain period of time.
Thus, the fundamental principle behind the concept of time value of money is that, a sum of
money received today, is worth more than if the same is received after a certain period of time.
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CAPITAL BUDGETING/INVESTMENT DECISION - A CONCEPTUAL

FRAMEWORK
When a business buys fixed assets, or when it spends money to increase the value of its existing
fixed assets, this expenditure is called capital expenditure (CAPEX). Fixed assets can be tangible
fixed assets such as land, buildings, plant & machinery or intangible fixed assets such as brands,
goodwill, patents and copy rights. Capital items are long-term and have an enduring influence on
the profit-making and wealth-creating capacity of a business.
Capital budgeting is a vital managerial tool for investment decision-making. One of the major
duties of a financial manager is to choose an investment from various alternatives considering
factors such as cash flows and rates of return. Therefore, a financial manager must be able to
decide whether an investment is worth undertaking and be able to choose intelligently between
two or more alternatives. To do this, a sound procedure for evaluating, comparison, and selection
of projects is needed.
The word Capital refers to be the total investment of a company of firm in money, tangible and
intangible assets. Whereas budgeting defined by the “Rowland and William” it may be said to
be the art of building budgets. Budgets are a blue print of a plan and action expressed in
quantities and manners. The examples of capital expenditure:
1. Purchase of fixed assets such as land and building, plant and machinery, good will, etc.
2. The expenditure relating to addition, expansion, improvement and alteration to the fixed
assets.
3. The replacement of fixed assets.
4. Research and development project.
Definitions
According to the definition of Charles T. Hrongreen, “capital budgeting is a long-term
planning for making and financing proposed capital out lays.
According to the definition of G.C. Philippatos, “capital budgeting is concerned with the
allocation of the firms source financial resources among the available opportunities. The
consideration of investment opportunities involves the comparison of the expected future streams
of earnings from a project with the immediate and subsequent streams of earning from a project,
with the immediate and subsequent streams of expenditure”.
According to the definition of Richard and Green law, “capital budgeting is acquiring inputs
with long-term return”.
According to the definition of Lyrich, “capital budgeting consists in planning development of
available capital for the purpose of maximizing the long-term profitability of the concern”.
It is clearly explained in the above definitions that a firm’s scarce financial resources are
utilizing the available opportunities. The overall objective of a firm is to maximize the profits
and minimize the expenditure of cost.
NATURE OF CAPITAL BUDGETING:
Capital expenditure budget or capital budgeting is a process of making decisions regarding
investments in fixed assets which are not meant for sale such as land, building, machinery or
furniture.
The word investment refers to the expenditure which is required to be made in connection with
the acquisition and the development of long-term facilities including fixed assets. It refers to
process by which management selects those investment proposals which are worthwhile for
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investing available funds. For this purpose, management is to decide whether or not to acquire,
or add to or replace fixed assets in the light of overall objectives of the firm.
What is capital expenditure is a very difficult question to answer. The terms capital expenditure
are associated with accounting. Normally capital expenditure is one which is intended to benefit
future period i.e., in more than one year as opposed to revenue expenditure, the benefit of which
is supposed to be exhausted within the year concerned.
Nature of Capital Budgeting can be explained in brief as under:
a) Capital expenditure plans involve a huge investment in fixed assets.
b) Capital expenditure once approved represents long term investment that cannot be reserved or
withdrawn without sustaining loss.
c) Preparation of capital budget plans involve forecasting, of several years profits in advance in
order to judge the profitability of projects.
d) In view of the investment of large amount for a fairly long period of time, any error in the
evaluation of investment projects, may lead to serious consequences; financially and otherwise
and may adversely affect the other future plans of the organisations.
NEED AND IMPORTANCE OF CAPITAL BUDGETING:
The need of capital budgeting can be emphasized taking into consideration the very nature of the
capital expenditure such as heavy investment in capital projects, long-term implications for the
firm, irreversible decisions and complicates of the decision making. Its importance can be
illustrated well on the following other grounds:
1. Huge investments:
Capital budgeting requires huge investments of funds, but the available funds are limited,
therefore the firm before investing projects, plan are control its capital expenditure.
2. Long-term:
Capital expenditure is long-term in nature or permanent in nature. Therefore financial risks
involved in the investment decision are more. If higher risks are involved, it needs careful
planning of capital budgeting.
3. Irreversible:
The capital investment decisions are irreversible, are not changed back. Once the decision is
taken for purchasing a permanent asset, it is very difficult to dispose off those assets without
involving huge losses.
4. Long-term effect:
Capital budgeting not only reduces the cost but also increases the revenue in long-term and will
bring significant changes in the profit of the company by avoiding over or more investment or
under investment. Over investments leads to be unable to utilize assets or over utilization of
fixed assets. Therefore before making the investment, it is required carefully planning and
analysis of the project thoroughly.
5. Indirect Forecast of Sales:
The investment in fixed assets is related to future sales of the firm during the life time of the
assets purchased. It shows the possibility of expanding the production facilities to cover
additional sales shown in the sales budget. Any failure to make the sales forecast accurately
would result in over investment or under investment in fixed assets and any erroneous forecast of
asset needs may lead the firm to serious economic results.
6. Comparative Study of Alternative Projects:
Capital budgeting makes a comparative study of the alternative projects for the replacement of
assets which are wearing out or are in danger of becoming obsolete so as to make the best
possible investment in the replacement of assets. For this purpose, the profitability of each
projects is estimated.
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7. Cash Forecast:
Capital investment requires substantial funds which can only be arranged by making determined
efforts to ensure their availability at the right time. Thus it facilitates cash forecast.
8. Worth-Maximization of Shareholders:
The impact of long-term capital investment decisions is far reaching. It protects the interests of
the shareholders and of the enterprise because it avoids over-investment and under-investment in
fixed assets. By selecting the most profitable projects, the management facilitates the wealth
maximization of equity share-holders.
9. Other Factors:
The following other factors can also be considered for its significance:-
(a) It assist in formulating a sound depreciation and assets replacement policy.
(b) It may be useful n considering methods of coast reduction. A reduction campaign may
necessitate the consideration of purchasing most up-to—date and modern equipment.
(c) The feasibility of replacing manual work by machinery may be seen from the capital forecast
be comparing the manual cost an the capital cost.
(d) The capital cost of improving working conditions or safety can be obtained through capital
expenditure forecasting.
(e) It facilitates the management in making of the long-term plans an assists in the formulation of
general policy.
(f) It studies the impact of capital investment on the revenue expenditure of the firm such as
depreciation, insure and there fixed assets.
OBJECTIVES OF CAPITAL BUDGETING
The following are the .important objectives of capital budgeting:
(1) To ensure the selection of the possible profitable capital projects.
(2) To ensure the effective control of capital expenditure in order to achieve by forecasting
the long-term financial requirements.
(3) To make estimation of capital expenditure during the budget period
(4) Determining the required quantum takes place as per authorization and sanctions.
(5) To facilitate co-ordination of inter-departmental project funds among the competing capital
projects.
(6) To ensure maximization of profit by allocating the available investible.
AREAS OF CAPITAL BUDGETING DECISIONS:
A business organization has to face quite often the problem of capital investment decisions.
Capital investment refers to the investment in projects whose results would be available only
after a year. The investments in these projects are quite heavy and to be made immediately, but
the return will be available only after a period of time. The following are some of the areas
where heavy capital investment may be necessary.
i. Replacement:
Replacement of fixed assets may become necessary either on account of their being worn out or
becoming outdated on account of new technology.
ii. Expansion:
A firm may have to expand its production capacity on account of high demand for its products
and inadequate production capacity. This will need additional capital investment.
iii. Diversification:
A business may like to reduce its risk by operating in several markets rather than in a single
market. In such an event, capital investment may become necessary for purchase of new
machinery and facilities to handle the new products.
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iv. Research and Development:

Large sums of money may have to be spared for research and development in case of those
industries where technology is rapidly changing. In case large sums of money are needed for
equipment, these proposals will normally be included in the capital budget.
v. Miscellaneous:
A firm may have to invest money in projects which do not directly help in achieving profit
oriented goals. For example, installation of pollution control equipment may be necessary on
account of legal requirements. Thus, funds will be required for such purposes also.
FACTORS INFLUENCING INVESTMENT DECISIONS
There are many factors which directly or indirectly, influence capital investment decisions,
beside the availability of funds to invest, profitability of the investment, market for the product,
etc. they are as below:
1. Technological Changes:
Technological development changes at present is much more faster than that at past. The new
technology increases the productivity of labour and capital. The selection of new technology
depends on the net benefit over the cost of having the technology. Benefits from and cost of new
technology also influences the investment decision.
2. Competitors’ Strategy:
If the competitors are installing the new equipment to expand output or to improve of their
products, the firm under consideration will have no alternative but to follow suit, else it will be
loss. It is therefore, often found that the competitor's strategy regarding capital investment plays
a very significant role in forcing capital decision of the firm.
3. Demand Forecast:
The long term demand forecast is one of the determinants of investment decision. If the firm
finds market potentials for the product in the long run, the firm will have to take decision for
investment.
4. Outlook of Management:
Investment decision depends on the management outlook. If the management is progressive in its
outlook, the innovations will be encouraged.
5. Fiscal Policy:
Various tax policies of the government relating the tax concession on prioritized investment
rebate on new investment, methods allowing depreciation deduction allowance etc. Also have
influence on the capital investment.
6. Cash Flow:
Every firm makes a cash flow budget. Its analysis influences capital investment decision. On the
basis of each cash flow budget the firm plans the funds for acquiring the capital assets. The
budget also shows the timing of availability of cash flows for alternative investment proposals.
7. Expected Return from the Investment:
Investment decisions are mostly done anticipation of increased return future. So, it is necessary
to estimate future net returns from the investment proposals while evaluating the investment
proposals.
8. Non-Economic Factors:
The factors which cannot be evaluated in money terms is called non-economic terms or factors.
Sometime the non-economic factors also influence investment decisions. Working environment
in the firm, safety measures in the operation of machines, brotherhood and good relation among
employer and employees, etc. influences the firm's output and also the investment decision.
KINDS OF CAPITAL BUDGETING DECISIONS
A firm may have several investment proposals for its consideration. It may adopt one of them,
some of them or all of them depending upon whether they are independent, contingent or
dependant or mutually exclusive.
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1. Independent Proposals:
These are proposals which do not compete with each other in a way that acceptance of one
precludes the possibility of acceptance of another. In case of such proposals the firm may straight
away “accept or reject” a proposal on the basis of minimum return on investment required. All
those proposals which give a higher return than a certain desired rate of return are accepted and
the rest are rejected.
2. Contingent or Dependant Proposals:
These are proposals whose acceptance depends on the acceptance of one or more other
proposals. For e.g. A new machine may have to be purchased on account of substantial
expansion of plant. In this case investment in the machine is dependent upon the expansion of
the plant. When a contingent investment proposal is made, it should also contain the proposal on
which it is dependant in order to have a better perspective in the situation.
3. Mutually Exclusive Proposals:
These are proposals which compete with each other in a way that the acceptance of one
precludes the acceptance of other/s. For eg. If a company is considering investment in one of two
temperature control system, acceptance of one system will rule out the acceptance of other. Thus,
two or more mutually exclusive proposals cannot be accepted simultaneously. Some techniques
have to be used for selecting the better or the best one. Once it is done, other alternatives
automatically get eliminated.
CAPITAL BUDGETING PROCESS
Capital budgeting is a difficult process to the investment of available funds. The benefit will
attained only in the near future but, the future is uncertain. However, the following steps
followed for capital budgeting, then the process may be easier are.
1. Identification of various investments proposals:
The capital budgeting may have various investment proposals. The proposal for the investment
opportunities may be defined from the top management or may be even from the lower rank.
The heads of various departments analyse the various investment decisions, and will select
proposals submitted to the planning committee of competent authority.
2. Screening or matching the proposals:
The planning committee will analyse the various proposals and screenings. The selected
proposals are considered with the available resources of the concern. Here resources referred as
the financial part of the proposal. This reduces the gap between the resources and the investment
cost.
3. Evaluation:
After screening, the proposals are evaluated with the help of various methods, such as payback
period proposal, net discovered present value method, accounting rate of return and risk analysis.
Each method of evaluation used in detail in the later part of this chapter. The proposals are
evaluated by.
(a) Independent proposals
(b) Contingent of dependent proposals
(c) Partially exclusive proposals.
Independent proposals are not compared with other proposals and the same may be accepted or
rejected. Whereas higher proposals acceptance depends upon the other one or more proposals.
For example, the expansion of plant machinery leads to constructing of new building, additional
manpower etc. Mutually exclusive projects are those which competed with other proposals and
to implement the proposals after considering the risk and return, market demand etc.
4. Fixing property:
After the evolution, the planning committee will predict which proposals will give more profit
or economic consideration. If the projects or proposals are not suitable for the concern’s financial
condition, the projects are rejected without considering other nature of the proposals.
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5. Final approval:
The planning committee approves the final proposals, with the help of the following:
(a) Profitability
(b) Economic constituents
(c) Financial violability
(d) Market conditions.
The planning committee prepares the cost estimation and submits to the management.
6. Implementing:
The competent authority spends the money and implements the proposals. While implementing
the proposals, assign responsibilities to the proposals, assign responsibilities for completing it,
within the time allotted and reduce the cost for this purpose. The network techniques used such
as PERT and CPM. It helps the management for monitoring and containing the implementation
of the proposals.
7. Performance review of feedback:
The final stage of capital budgeting is actual results compared with the standard results. The
adverse or unfavourable results identified and removing the various difficulties of the project.
This is helpful for the future of the proposals.
RATIONALE OF CAPITAL EXPENDITURES:
i. Expenditure made to reduce costs:
Expenditures in this class do not affect the quantity of production or sales of the firm but are
intended to reduce or minimize the cost of production. This type of expenditure arises in the
choice of production process (e.g. capital intensive or labour intensive) and in equipment
replacement decisions.
ii. Expenditure made to increase revenues:
Expenditures for new plant to increase production capacity and expenditures to stimulate
demand, either through advertising or through product improvement. Since expenditures in this
class are expected to influence the quantity sold, costs as well as revenues must be considered in
their analysis.
iii. Expenditures justified on non-economic grounds:
The economic rationale for other capital expenditures may be less clear-cut. For example, it is
hard to quantify in rupees the benefits which accrue to a company from building recreation
facilities for its employees, to provide hospital statement of the costs involved for such type of
projects is necessary to make a more reasoned decision.
CRITICALITIES OF CAPITAL BUDGETING:
Faced with limited sources of capital, management should carefully decide whether a particular
project is economically acceptable. In the case of more than one project, management must
identify the projects that will contribute most to profits and, consequently, to the value (or
wealth) of the firm. This, in essence, is the basis of capital budgeting. The extent to which a firm
will achieve its main objective of maximizing wealth of its shareholders will significantly
depend on its capital budgeting decisions.
There are various reasons responsible for these arguments which are discussed below.
i. Profitability:
Capital budgeting decisions affect the profitability of a business firm. It decides the efficiency of
working of a firm and its competing position in an industry as they relate to investment in and
management of fixed assets. In fact, fixed assets are real earning assets of any company. It
enables the firm to manufacture and sale desired product which ultimately yields profits for the
firm and in turn wealth for its shareholders.
ii. Huge amount of funds:
Second reason which indicates its significance is huge amount of funds are required to purchase
and execute any capital expenditure proposal. Moreover, it has long term impact on the firms’
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future returns as all such decisions are long term in nature and it affects firm’s future cost
structure. For instance, if a firm is planning for expansion and invests in a new plant, the firm has
to keep a provision for substantial amount of funds for recurring fixed costs in terms of direct
labour cost, supervisor’s salary, insurance, rent of newly acquired space to install the plant etc.
iii. Irreversibility:
Further, capital budgeting decisions are irreversible in nature. Once the capital budgeting
decision is taken and executed it is very difficult to find market for the asset in case the company
feels that decision taken is wrong and they want to change it. Suppose the new project fails or do
not generate desired return for some or other reasons, the firm will have to bear the burden of
fixed costs for a long time (at least beyond a year) unless it writes off the investment completely
which means substantial financial loss to the firm which all firms may not be in a positions to
bear even if it’s a well established firm. It may endanger the survival of the firm sometimes.
Therefore, it is apprehended that incorrect investment decisions can adversely affect not only the
growth but even the survival of the firm while sound capital budgeting decisions can fetch
spectacular return and have the potential to change the fortunes of the weak and marginal firms.
CAPITAL BUDGETING- TECHNIQUES OF EVALUATION
The investment decision rules may be referred to as capital budgeting techniques, or investment
criteria. A sound appraisal technique should be used to measure the economic worth of an
investment project. The essential property of a sound technique is that is should maximize the
shareholders wealth. The following other characteristics should also be possessed by a sound
investment evaluation criterion.
The following are the capital budgeting appraisal methods or techniques:
(A) Traditional methods (or Non-discount methods)
(i) Pay-back Period Methods
(ii) Accounts Rate of Return
(B) Modern methods (or Discount methods)
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method

Methods of Capital Budgeting

Traditional Modern
Methods Methods

Pay back Accounting Net Present Internal Rate of Profitability

Period Rate of Return Value Method Return Method Index Method
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A. Traditional methods
(i) Pay-back Period Methods:
Pay-back period is the time required to recover the initial investment in a project. It is the
simplest and perhaps, the most widely used quantitative method for appraising capital
expenditure decision.
This technique can be used to compare actual pay back with a standard pay back set up by the
management in terms of the maximum period during which the initial investment must be
recovered. The standard PBP is determined by management subjectively on the basis of a
number of factors such as the type of project, the perceived risk of the project etc. PBP can be
even used for ranking mutually exclusive projects. The projects may be ranked according to the
length of PBP and the project with the shortest PBP will be selected.
Initial investment
Pay-back period =
Annual cash inflows
Merits of Pay-back method
The following are the important merits of the pay-back method:
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement over the accounting rate return.
3. Pay-back method reduces the possibility of loss on account of obsolescence.
Demerits
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back period.
3. It is one of the misleading evaluations of capital budgeting.
Accept /Reject criteria
If the actual pay-back period is less than the predetermined pay-back period, the project would
be accepted. If not, it would be rejected.
(ii) Accounting Rate of Return or Average Rate of Return Method (ARR) :
Average rate of return means the average rate of return or profit taken for considering the
project evaluation. This method is one of the traditional methods for evaluating the project
proposals:
(i) Whenever it is clearly mentioned as Accounting Rate of Return:
Average Annual EAT
Accounting Rate of Return (ARR) = ×100
Original Investment*

* Original Investment = Original Investment + additional NWC + Installation Charges +

Transportation Charges
(ii) Whenever it is clearly mentioned as Average Rate of Return:
Average Annual EAT
Average Rate of Return (ARR) = ×100
Average Investment*

* Average Investment = (Original Investment – Scrap Value)/2+Additional NWC+ Scrap Value

(iii) If ARR is given in the problem, any one of the above methods can be used to calculate ARR
(preferably return on average investment method). The computation of ARR is based on the
cash flows after taxes only.
Merits of ARR Method
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
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3. It is not based on the time value of money.

4. It considers the total benefits associated with the project.
Demerits of ARR Method
1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to some difficulties in the
calculation of the project.
Accept/Reject criteria
If the actual accounting rate of return is more than the predetermined required rate of return, the
project would be accepted. If not it would be rejected.
B. Modern Methods:
(i) Net Present Value Method:
Net present value method is one of the modern methods for evaluating the project
proposals. In this method cash inflows are considered with the time value of the money. Net
present value describes as the summation of the present value of cash inflow and present value of
cash outflow. Net present value is the difference between the total present value of future cash
inflows and the total present value of future cash outflows. Computation of NPV is based on the
cash flows after taxes but before depreciation.
Merits
1. It recognizes the time value of money.
2. It considers the total benefits arising out of the proposal.
3. It is the best method for the selection of mutually exclusive projects.
4. It helps to achieve the maximization of shareholders’ wealth.
Demerits
1. It is difficult to understand and calculate.
2. It needs the discount factors for calculation of present values.
3. It is not suitable for the projects having different effective lives.
Accept/Reject criteria
If the present value of cash inflows is more than the present value of cash outflows, it would be
accepted. If not, it would be rejected.
(ii) Internal Rate of Return Method:
Internal rate of return is time adjusted technique and covers the disadvantages of the
traditional techniques. In other words it is a rate at which discount cash flows to zero.
Otherwise, the rate which discounts the cash flows to zero is called internal rate of return.
The internal rate of return on an investment or project is the "annualized effective compounded
return rate" or discount rate that makes the net present value of all cash flows (both positive and
negative) from a particular investment equal to zero.
In more specific terms, the IRR of an investment is the interest rate at which the net present
value of costs (negative cash flows) of the investment equals the net present value of the benefits
(positive cash flows) of the investment.
Computation of IRR is based on the cash flows after taxes but before depreciation. IRR is
mathematically represented as ‘r’. It can be found out by trail and effort method. In this method
cost of capital is taken as first trail. If the calculated present value of the cash inflows is higher
than the present value of cash outflows, then the evaluator has to try at a higher discount rate.
On the other hand, if the present value of cash inflows is lower than the present value of cash
outflows then the evaluator has to try lower discount factor. This process will be repeated till the
present value of cash inflows equals to the present value of cash outflows. Generally, IRR may
lie between two discount factors; in that case the analyst has to use interpolation formula for
calculation of IRR.
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D1
IRR = L + ×D
D2
Where,
L = Lowest discount factor
D1 = Difference between discounted cash flow at L and cash outflows ( N.V.P at low rate)
D2= Difference between discounted cash flow at L and discounted cash flows at the highest of
the two rates.
D = Difference between the two rates.
Merits
1. It consider the time value of money.
2. It takes into account the total cash inflow and outflow.
3. It does not use the concept of the required rate of return.
4. It gives the approximate/nearest rate of return.
Demerits
1. It involves complicated computational method.
2. It produces multiple rates which may be confusing for taking decisions.
3. It is assume that all intermediate cash flows are reinvested at the internal rate of return.
Accept/Reject criteria
If the present value of the sum total of the compounded reinvested cash flows is greater than the
present value of the outflows, the proposed project is accepted. If not it would be rejected.
NPV and IRR – Key Differences:
• IRR assumes that the cash flows are reinvested in the projected at the same discount rate.
This is a major limitation for the use of IRR. NPV makes no such assumption.
• NPV is measured in terms of currency whereas IRR is measured in terms of expected
percentage return.
• If NPV calculation uses different discount rates, then it produces different results for the
same project. But, IRR always gives the same result. For the same reason, given a choice
between NPV vs IRR, managers generally prefer IRR because it is easier and less
confusing.
• From a comparison of NPV and IRR, it can be seen that NPV is actually a better measure
than IRR, especially, in long term projects, not only because NPV considers different
discount rates but also takes into account the cost of capital.
Conflict between NPV and IRR:
When we are analyzing a single conventional project, both NPV and IRR will provide the same
indicator about whether to accept the project or not. However, when comparing two projects, the
NPV and IRR may provide conflicting results. It may be so that one project has higher NPV
while the other has a higher IRR. This difference could occur because of the different cash flow
patterns in the two projects.
(iii) Profitability Index:
Profitability index is an investment appraisal technique calculated by dividing the present
value of future cash flows of a project by the initial investment required for the project. The
profitability index is also known as discounted benefit cost ratio (DBCR). It can be calculated as
follows:
Present Value of Future Cash Flows
PI =
Initial Investment Required
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Profitability index is actually a modification of the net present value method. While present
value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profitability
index is a relative measure (i.e. it gives as the figure as a ratio).
Decision Rule
Accept a project if the profitability index is greater than 1, stay indifferent if the profitability
index is zero and don't accept a project if the profitability index is below 1.
Profitability index is sometimes called benefit-cost ratio too and is useful in capital
rationing since it helps in ranking projects based on their per dollar return.
Advantages of Profitability Index (PI):
1. PI considers the time value of money.
2. PI considers analysis all cash flows of entire life.
3. PI makes the right in the case of different amount of cash outlay of different project.
4. PI ascertains the exact rate of return of the project.
Disadvantages of Profitability Index (PI):
1. It is difficult to understand interest rate or discount rate.
2. It is difficult to calculate profitability index if two projects having different useful life.

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