1. Comparison of NPV,
IRR Methods and PI
Methods
Presented by:
Raymund Ramos
Kharen E. Tabajonda
2. Road map
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RECAP OF CAPITAL
BUDGETING
KEY DIFFERENCE OF NPV
VS IRR
NPV AND IRR PI METHOD
ADVANTAGE AND
DISANVANTAGES OF
USING NPV, IRR AND PI
3. CAPITAL
BUDGETING
the process that a business uses to
determine which proposed fixed asset
purchases it should accept, and which
should be declined. This process is used
to create a quantitative view of each
proposed fixed asset investment, thereby
giving a rational basis for making a
judgment.
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4. ✔NET PRESENT VALUE,
INTERNAL RATE OF RETURN
PROFITABILITY INDEX
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Net present value = “Present value of cash all Inflows” – “Present value of all cash
Outflows”.
Example: Your pay slip
Net Salary = Gross Salary - Deductions Similarly:
Net Present value is : All Cash Inflows – All Cash Outflows.
➢IF NPV > 0 (positive), The project can be accepted, The
greater the NPV, the better the project financial benefits.
5. Net Present Value
Example: Calculating NPV
A sum of $ 400,000 dollars invested today in an IT
project may give a series of below cash inflows in
future:
$ 70,000 in year 1
$ 120,000 in year 2
$ 140,000 in year 3
$ 140,000 in year 4
$ 40,000 in year 5
If Opportunity cost of capital is 8% per annum, then
should we accept or reject the project?
NET PRESENT VALUE
6. Calculating NPV however with Discount rate or
Opportunity cost of capital at 15%
A sum of $ 400,000 dollars invested today in an IT
project may give a series of below cash inflows in
future:
$ 70,000 in year 1
$ 120,000 in year 2
$ 140,000 in year 3
$ 140,000 in year 4
$ 40,000 in year 5
If Opportunity cost of capital is 15% per annum,
then should we accept or reject the project?
NET PRESENT VALUE
7. NET PRESENT VALUE
✔ INTERNAL RATE OF RETURN
PROFITABILITY INDEX
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IRR (Internal Rate of Return) is a
discount rate at which NPV (Net
Present Value) becomes Zero.
In other words, IRR is the opportunity
cost at which the NPV becomes Zero.
IRR as the name suggests, it tells how
much rate of return (percent) we are
getting from the project. To put it
simple: It is the percentage of Return of
your investment
Why IRR, what is the use of calculating IRR?
➢IRR is used to rank different projects.
➢The higher a project's internal rate of
return, the more desirable it is to
undertake the project.
➢If all the other factors are same for
different projects then the project with the
Highest Internal rate of return value
should be considered.
8. INTERNAL RATE OF RETURN
Accept the project when Internal rate
of return > Discount rate or
Opportunity cost of capital.
Reject the project when Internal rate
of return < Discount rate or
Opportunity cost of capital.
May accept the project when Internal
rate of return = Discount rate or
Opportunity cost of capital.
Relationship between IRR, Discount rate and NPV
If IRR > Discount rate or Opportunity
cost of capital → The NPV is always
Positive.
If IRR < Discount rate or Opportunity
cost of capital → The NPV is always
Negative.
If IRR = Discount rate or Opportunity
cost of capital → The NPV is Zero.
Note: As long as the NPV is Positive, the project is financially viable.
The moment that NPV becomes Negative, the Project is NOT financially viable.
9. Example:
The cost of a project is $1000. It has a time
horizon of 5 years and the expected year wise
incremental cash flows are:
Year 1 : $200
Year 2: $300
Year 3 : $300
Year 4: $400
Year 5 : $500
Compute IRR of the project. If opportunity cost of
Capital is 12%, And tell us, should we accept the
project?
INTERNAL RATE OF RETURN
10. NET PRESENT VALUE
INTERNAL RATE OF RETURN
✔ PROFITABILITY INDEX
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-measure of a project's or investment's
attractiveness.
Project acceptance criteria using Profitability Index
method.
➢Accept the project when PI > 1
Reject the project when PI < 1
May accept the project when PI = 1
Higher the profitability Index of the
project, the better.
FORMULA: Present Value of all future cash inflows
Cash outflows
Profitability index is a ratio between the discounted
cash inflow to the initial cash outflow. It presents a
value which says how many times of the
investment is the returns in the form of discounted
cash flows.
11. A sum of $ 25,000 invested today in a project may
give a series of cash
inflows in future as described below:
$ 5000 in year 1
$ 9000 in year 2
$ 10,000 in each of year 3
$ 10,000 in each of year 4
$ 3000 in year 5
If the required rate of return is 12% pa, what is
the Profitability Index?
PROFITABILITY INDEX
12. NET PRESENT VALUE INTERNAL RATE OF RETURN
● is an absolute sum
● If the cash flow changes, the net present value can be taken
into use
● If the Net presentvalue of a project is positive, then the
same can be accepted.
● The net present value method is the PV of cash flows.
● Evaluates additional wealth
● Intermediate cash inflows and outflows can be reinvested
at a cut-off rate
● suitable for projects that are supposed to continue for a
longer span of time
● NPV method considers the rate of interest as a known
factor
● is a relative sum
● If the cash flow changes, the internal rate of return cannot be
taken into use
● A project in IRR can be accepted if its internal rate of return
is higher than its weighted average cost of capital.
● the internal rate of return method is the discount rate that
makes the net present value of cash flow equal to zero.
● Cannot evaluate additional wealth
● In an IRR method, intermediatecash inflows and outflows are
assumed to be reinvested at IRR.
● is suitable for projects that are supposed to continue for a
shorter span of time.
● IRR method considers the rate of interest as an unknown
factor
KEY DIFFERENCE BETWEEN NPV VS IRR
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13. NET PRESENT VALUE INTERNAL RATE OF RETURN
● NPV of a project is determined and expressed as a
currency or monetary
● The aggregate of all presentvalue of the cash flows of an
asset, immaterial of positive or negative is known as Net
Present Value.
● The purpose of calculation of NPV is to determine the
surplus from the project
● IRR of a project is determined and expressed in the form of
percentagereturn.
● Internal Rate of Return is the discountrate at which NPV = 0.
● IRR represents the state of no profit no loss.
KEY DIFFERENCE BETWEEN NPV VS IRR
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14. Basis of Comparison
Basis of comparison NPV IRR
Full form The full form for NPV is Net Present Value.
The full form for IRR is the Internal Rate
of Return.
Definition
NPV may be defined as a difference
arrived when the present value of the cash
outflows is deducted from the present
value of cash inflow.
IRR can be defined as the discount rate
that can make the net present value of
all the cash inflow equal to 0.
Calculation
Net Present Value is calculated in the form
of currency or monetary return.
Internal Rate of Return is calculated in
the form of percentage return.
Measure Absolute measure. Relative measure.
Evaluation of projects when there
are constant movements in cash
flows.
The NPV method can be used for the
evaluation of projects/ investment plans
even when there is a constant movement
in cash flows.
IRR method cannot be taken into use for
the evaluation of projects when there is a
constant movement in cash flows; that
is, when there is a combination of
negative and positive cash flows.
Flexibility Flexible. Not that flexible.
Additional wealth
The Net Present Value method can
evaluate additional wealth.
The internal Rate of Return method
cannot evaluate additional wealth.
ROI or rate of interest
The net present value method considers
ROI to be a known factor.
The internal rate of return method does
not consider ROI to be a known factor.
Suitability with respect to the
tenure of the projects.
The net present value method is suitable
with respect to the projects that are
supposed to continue for a longer duration
of time.
The internal rate of return method is
suitable with respect to the projects that
are supposed to continue for a shorter
span of time.
