Net Present Value, Internal Rate of Return and Profitability Index Method of Capital Budgeting

1. Accounting Rate of Return (ARR)
 Accounting Rate of Return (ARR), also popularly known as the average rate of
return measures the expected profitability from any capital investment.
 It shows the percentage rate of return that is expected on an asset or investment.
This is when it is compared to the initial average capital cost of the investment.
 ARR= Average Annual Income after tax & Depreciation *100
 Average Investment
 Average Investment(AI)= original Investment/2
 AI = (Original Investment – Scrap Value) + Additional Working Capital +
Salvage Value
 2
Annual Average Net Earnings=Total Income after Tax & Depreciation / Estimated
Life of Project

2. Advantages of ARR:
• It is easy to calculate.
• This method takes into account saving over the entire economic life of the
project.
• This method through the concept of “Net Earnings”
• It can be calculated by using the accounting data.
Dis-advantages:
• It ignores the time value of money.
• It is not consistent with the firms objective of maximizing the market value
of shares.
• It ignores the fact that the profits earned can be reinvested.

3. Net Present Value Method (NPV)
 It is a discounted cash flow method that considers the time value of
Money concept while evaluating the capital investments.
 It is used to determine the value of an investment by comparing the present
value of its expected cash inflows to the initial investment cost.
 NPV= Present Value of Expected cash Inflow- Initial Investment
 NPV=PVI - PVO
 PVB = Present value of Inflows
 PVC = Present value of Outflows
 Accept/ Reject Criteria:
 For Independent Project, NPV= +ve
 For Mutually Exclusive Project- The projects having higher NPV should
be accepted.

4. • Advantages of NPV
• Considers the time value of money
• Accounts for all expected cash inflows and outflows
• Provides a measure of the investment’s profitability
• Can be used to compare multiple investment opportunities
 Dis-advantages:
• Requires accurate estimates of future cash flows and discount rates
• Can be complex and time-consuming to calculate
• Does not consider non-financial factors such as environmental impact
or social responsibility.

5. Profitability Index (PI)
It is also known as Benefit Cost (B/C) ratio. It is similar to
NPV method.
It is the ratio of total present value of cash Inflows equals to
cash outflows.
PI = Total Present Value of Cash Inflow/ )Original
Investment
Accept/Reject Criteria:
Accept if PI > 1
Reject if PI < 1

6. Internal Rate of Return (IRR)
 It is the rate at which the sum of discounted cash Inflows equals to sum
of the discounted cash outflows.
 It is the rate at which NPV of investment is Zero.
 It is also known as time adjusted rate of return or trial and error
method. IRR= A + C-O/ C-D (B – A)
 Where A is Discount factor of Lower trial Rate
 B is discount factor of Higher Trial Rate
 C is Present value of Cash inflow at Lower Trial rate
 D is Present Value of Cash Inflow at Higher Trial Rate.
 O is Original Investment

7. • Advantages of IRR
• Considers the time value of money
• It considers the profitability
• Share Holders value.
• Can be used to compare multiple investment opportunities
Dis-advantages:
• Difficult to understand.
• Can be complex and time-consuming to calculate
 Based on Assumptions

8. Accept/Reject Criteria
Accept if IRR is higher or equal to minimum required
rate of return. The minimum rate of return is also known
as cut off rate or firms cost of capital.
 Rejected if IRR < Minimum rate of return
Accepted of IRR > Minimum rate of return
For two or more projects
Higher IRR would be prefereed.