Compare and contrast the Internal Rate of Return (IRR), the Net Present Value (NPV) and Payback approaches to capital rationing. Which do you think is better? Why? Solution Capital rationing is used when the capital is short or limited in supply and the organization cannot afford to choose all the projects. Therefore, organizations have to make best use of available capital resource and hence it chooses the project based on profitability. Internal rate of return is a rate of return at which NPV is zero. IRR is a measure of profitability. NPV or net present value is the difference between Present value of cash flows and initial investment. It measures the net addition to shareholders wealth. Payback period is the period of time the project takes to recover the initial investment. Payback period is the measure of liquidity. Profitability index is the best method when capital is rationed. If Profitability index method is not available, we should prefer using IRR method .

1. Compare and contrast the Internal Rate of Return (IRR), the Net Present Value (NPV) and
Payback approaches to capital rationing. Which do you think is better? Why?
Solution
Capital rationing is used when the capital is short or limited in supply and the organization
cannot afford to choose all the projects. Therefore, organizations have to make best use of
available capital resource and hence it chooses the project based on profitability. Internal rate of
return is a rate of return at which NPV is zero. IRR is a measure of profitability. NPV or net
present value is the difference between Present value of cash flows and initial investment. It
measures the net addition to shareholders wealth. Payback period is the period of time the project
takes to recover the initial investment. Payback period is the measure of liquidity.
Profitability index is the best method when capital is rationed. If Profitability index method is not
available, we should prefer using IRR method