There are several measures available to financial managers to assist them in dec

Question

There are several measures available to financial managers to assist them in deciding whether a specific project should be undertaken for the benefit of the company, including Average Accounting Return, Internal Rate of Return (IRR), Net Present Value (NPV), and Profitability Index (PI).

1) How are each of these measures computed? Under what circumstances might one or more of the measures be more appropriate than the others for analyzing projects, and why?

2) How do NPV and PI specifically relate to the primary goal of financial management?

Explanation / Answer

1) Accounting rate of return mean a holding period rate of return ie if you earn 120 on investment of 100 then accounting return is 20%. Discounting is not taken into consideration.

Internal Rate of Return is the rate at which Discounted cash inflows is equal to cash outflows.

NPV is the Cash outflows minus discounted cash inflows.

PI is the ratio of Discounted cash inflows to Cash outflows.

For the purpose of analysing projects, a project with the highest NPV should be selected. In case of indiendent projects all projects with positive NPV must be selected.

2) NPV is the incremental revenues ut of the project and it directly adds value of the organization.

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