Serious Limitations:
Cash flows after payback period is ignored
Cash flows patterns
Inconsistent with shareholder value
Accounting Rate of Return Method
Under this method, various projects are ranked
in order of the rate of return.
The project with the higher rate of return
compared to the minimum cut-off is selected
and the one with lower rate of return than the
cut-off is rejected.
ARR
There are 4 ways to find out ARR:
1.Average rate of return method
ARR= Average profits after depreciation
&Taxes/Net investments in the
projectx100
2. Return per unit of investment method
De-merits:
Cash flows ignored
Time value ignored
Arbitrary/Discretionary cut-off
Net Present Value Method
Cash flows of the investment project should be
forecasted based on realistic assumptions.
De-merits:
Involves cash flow estimation
Discount rate is difficult to determine
Mutually exclusive projects
Ranking of Projects
Profitability Index
Profitability Index is also called as Benefit-
Cost Ratio (B/C) or Desirability factor is
the relationship between present value of
the cash inflows and the present value of
cash outflows.
PI=PV of cash inflows/PV of cash outflows
Net PI=NPV/Initial cash outlay
Acceptance Rule
Accept the project when PI is greater than
one. PI > 1
Reject the project when PI is less than
one. PI < 1
May accept the project when PI is equal to
one. PI = 1
The project with positive NPV will have PI
greater than one. PI less than one means
that the project’s NPV is negative.
Evaluation of PI Method
It recognizes the Time Value of money.
It is consistent with the shareholder value
maximization principle.
In the PI Method, since the present value of
cash inflows is divided by the initial cash
outflow, it is relative measure of a project’s
profitability.
Like the NPV Method, PI criteria also requires
calculation of cash flows and estimate of the
discount rate.
Internal Rate of Return
The Internal Rate of Return (IRR) is the
rate that equates the investment outlay
with the present value of cash inflow
received after a period.
De-merits:
Multiple rates
Mutually exclusive projects
NPV versus IRR
NPV IRR
Here, the present value is Here, the discount rate is not
determined by discounting predetermined
the future cash flows of a
project at a predetermined
rate