Several measures available to financial managers to assist in deciding whether a

Question

Several measures available to financial managers to assist 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). How are each of thesee measures computed and under what circumstances might one or more of the measures be more appropriate than the other for analyzing projects, and why? How does NPV and PI specifically relate to the primary goal of financial management?

Explanation / Answer

1. Average Accounting return: This is also referred to averafe rate of return and is calculated as: PAT(profit after tax)/Book value of the investment.

Higher the accounting rate of return, the better the project is. The project is accepted if the average accounting rate of return is greater than the specified rate of return,

It is simple to calcuate and based on information that is readily avaibale. The drawback is it does not use time value of money

2. Profitability index: Here a relation is drawn between the present value of future cash flows as against the initial investment.

Profitability Index (PI) = Present Value of future cash flows/ Initial investement

A PI of 1 or greater than 1.0 indicates that project is profitable and is generally accepted. A PI of lower than 1, shows loss and the project is not acceptable.

3. Internal rate of return (IRR): It is defined as the discoun rate that makes the NPV equal to zero. In other words, the present value of the future cash flows are equated to the inital investment.

If the IRR is greater than cost of capital, then the project is accepted else it is rejected.

The disadvantage of using IRR is when the project is non conventional (both positive and negative cash flows during the tenure), the IRR is not relaible and gives two probabale values.

4. NPV: The net present value calclated the PV of all the future cash flows and subtracts the initial investment from the Present value.

If the NPV is greater than 0, the project is accepted. If the NPV is negative, the project is rejected.

The disadvantage is that it does not consider the life of the projecrt and is baised towards a long term project

NPV and PI take into account the time value of money and hence are more superior when compared to other methods of capital budgeting

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