Assignment on Capital Budgeting Methods: NPV, IRR, and PI

Index

1. Introduction …………………………………………………… 1
2. Net Present Value (NPV) ………………………………….. 2
3. Internal Rate of Return (IRR) ………………………….. 3
4. Profitability Index (PI) ……………………………………… 4
5. Comparison Table …………………………………………… 5
6. Conclusion ………………………………………………………. 6
7. References ………………………………………………………. 7

---

Introduction

Capital budgeting is one of the most important decision-making processes in financial management. It deals with evaluating and selecting long-term investments that are consistent with the goal of shareholder wealth maximization. Since investment decisions involve significant capital outlay and uncertain future returns, it is crucial to apply proper evaluation techniques. Among the widely used methods are Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI). This assignment compares these methods in terms of definition, decision rules, advantages, and limitations.

---

1. Net Present Value (NPV)

• Definition: NPV is the difference between the present value of cash inflows and the present value of cash outflows, discounted at the firm’s cost of capital.

• Decision Rule:

  • Accept the project if NPV > 0 (value creation).
  • Reject the project if NPV < 0 (value destruction).

• Advantages:

  • Considers time value of money.
  • Provides absolute value addition in monetary terms.
  • Consistent with shareholder wealth maximization.

• Limitations:

  • Requires accurate estimation of discount rate.
  • Not ideal for comparing projects of different sizes.

---

2. Internal Rate of Return (IRR)

• Definition: IRR is the discount rate that equates the present value of inflows with the present value of outflows (i.e., NPV = 0). It represents the project’s expected rate of return.

• Decision Rule:

  • Accept the project if IRR > cost of capital.
  • Reject the project if IRR < cost of capital.

• Advantages:

  • Easy to understand as a percentage return.
  • Facilitates comparison between projects of similar scale.

• Limitations:

  • Multiple IRRs possible if cash flows change signs.
  • Assumes reinvestment at IRR, which may not be realistic.
  • Can give conflicting results compared to NPV in mutually exclusive projects.

---

3. Profitability Index (PI)

• Definition: PI is the ratio of the present value of future cash inflows to the initial investment.

  • Formula: PI = PV of inflows ÷ PV of outflows.

• Decision Rule:

  • Accept the project if PI > 1.
  • Reject the project if PI < 1.

• Advantages:

  • Useful when capital is rationed.
  • Incorporates time value of money.
  • Helps in ranking projects based on efficiency.

• Limitations:

  • Requires discount rate estimation.
  • May be misleading for mutually exclusive projects.

---

Comparison Table

Method	Nature	Decision Rule	Advantages	Limitations
NPV	Absolute ($)	Accept if NPV > 0	Direct measure of value creation, consistent with wealth maximization	Needs discount rate, scale issues
IRR	Percentage (%)	Accept if IRR > cost of capital	Easy to interpret, widely used	Multiple IRRs, poor for mutually exclusive projects
PI	Ratio	Accept if PI > 1	Useful under capital rationing, good for ranking	Misleading with exclusive projects, discount rate needed

---

Conclusion

While all three methods—NPV, IRR, and PI—are widely used in capital budgeting, they are not equally reliable. NPV is theoretically the best method, as it directly measures value creation in monetary terms and aligns with the objective of maximizing shareholder wealth. IRR, though intuitive, can give conflicting results in certain cases, while PI is particularly useful in situations of capital rationing. In practice, firms often use a combination of these methods, with NPV serving as the primary decision-making criterion.

---

References

1. Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
2. Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). Wiley Finance.
3. Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.
4. Khan, M. Y., & Jain, P. K. (2018). Financial Management: Text, Problems and Cases. McGraw-Hill Education.
5. Van Horne, J. C., & Wachowicz, J. M. (2016). Fundamentals of Financial Management (13th ed.). Pearson Education.

---