Question

2 Briefly compare and contrast NPV, PI, and IRR criteria.

3. What are the advantages and disadvantages of each of the above methods?

4. Why capital budgeting is important?

Answer 1

1)

NPV is the excess of present value of all cash inflows over present value of cash outflows. It is technique of capital budgeting that helps a finance manager to evaluate various proposals. The project should be accepted only when NPV is greater than 0. This means the present value of all cash inflow is greater than present value of all cash outflows and the project is going to contribute in increasing the wealth of the shareholders.

NPV = Present value of cash inflows - present value of cash outflows.

Profitability index (PI) is variant of NPV technique. It is also known as benefit- cost ratio. It is calculated by dividing present value of all cash inflows to present value of cash outflows. Under PI technique, decision rule is - " Accept the project if PI is more than 1 and reject if it is less than 1."

PI = Present value of cash inflows / Present value of cash outflows.

IRR of a proposal is defined as the discount rate at which NPV is 0. It is the rate at which the present value of cash inflows is equal to present value of cash outflows. It is usually the rate of return the project earns. The decision rule is - "Accept the project in which the IRR is greater than cost of capital and reject where IRR is less than cost of capital."

Basis	NPV	PI	IRR
Meaning	NPV is the excess of present value of all cash inflows over present value of cash outflows.	It is index which is calculated by dividing present value of all cash inflows to present value of cash outflows.	It is the rate at which the present value of cash inflows is equal to present value of cash outflows.
Measure	It is absolute measure.	It is relative measure.	It is relative measure.
Decision rule	Accept the project if NPV is positive.	Accept the project if PI is more than 1	Accept the project in which the IRR is greater than cost of capital
Expressed	It is expressed in terms of currency.	It is expressed in terms of ratio.	It is expressed in terms of %

2) Advantages of NPV method -

• It takes in to account the time value of money.
• It has realistic reinvestment rate assumption. It assumes all the intermediate cash inflows are reinvested at cost of capital.
• NPV of 2 projects are additive.
• It shows the absolute increase in shareholder's wealth.

Disadvantages of NPV method -

• This method requires predetermination of required rate of return, which is difficult to calculate.
• It involves difficult calculation.
• The decision is taken based on absolute returns. It ignores difference in initial outflows, size of different proposals, etc.

Advantages of PI method -

• It is a relative measure.
• It takes in to consideration difference in initial outflows, size of different proposals, etc.
• It takes in to account the time value of money.

Disadvantages of PI method -

• This method requires predetermination of required rate of return, which is difficult to calculate.
• It involves difficult calculation of finding the present value of cash inflows and outflows.

Advantages of IRR method -

• No need to of discount rate, IRR itself provides the rate which is the return of the project.
• It is easy to understand.
• It considers time value of money.
• It is consistent with wealth maximisation objective of shareholders.

Disadvantages of IRR method -

• It involves difficult calculations to find out IRR.
• It is based on assumption that the intermediate cashflows are reinvested at IRR which is unrealistic.

3) Capital budgeting decision is related to allocation of funds to different long term projects. It involves investment in long term assets. It requires huge capital initially and provides return over a period in future. The significance of capital budgeting may be stated as follow:

1. It involves huge funding. It involves large commitment of funds and the capital funds are blocked in capital budgeting decisions for a long period of time. So, it is very important to choose a project wisely.
2. Most of the capital budgeting decisions are irreversible decisions. Once taken the firm may not be in a position revert back unless heavy losses. Therefore, it should be taken only after evaluating each detail of the project.
3. The decision to invest in particular project impacts future growth of the firm.
4. The capital budgeting decisions have long term effects and have risks. The decisions have long term implications and consequences. Hence, it very important to take a decision only after considering every detail of a project.

Hope it helps!