Page 137 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes confined to the initial period (i.e. in the beginning) followed by cash inflows. The independent
proposals refer to investment, the acceptance of which does not preclude the acceptance of
others, so that all profitable proposals can be accepted and there are no constraints. The decision
rule is that a proposal will be accepted if
1. NPV exceeds zero,

2. IRR exceeds the required rate of return.
Similarly, when NPV = Zero or the IRR = required rate of return, the project may be accepted or
rejected.
Differences: In case of mutually exclusive capital project i.e., the acceptance of an investment
precludes the acceptance of others (i.e. if there are alternative courses of action, only one can be
accepted). Mutual exclusiveness of the investment projects may be technical or financial. Technical
means projects with different profitabilities and selection of the more profitable. Financial
means resource constraints, which is also called capital rationing.
The different ranking by NPV and IRR methods can be due to the following:

1. Size disparity
2. Time disparity
3. Unequal expected lives.
As stated earlier, the IRR criterion implicitly assumes that the cash flow generated by the project
will be reinvested at the internal rate of return, as opposed to company's cost of capital in case
of NPV. The assumption of the NPV method is considered to be superior since the rate can be
consistently applied to all investment proposals.

6.4.1 Net Present Value vs Profitability Index

The investment proposal will be acceptable if:

1. PI is greater than one.
2. Positive Net Present Value.
Likewise, PI will be less than I when the investment proposal has a negative net present value
under the NPV method.

!
Caution While evaluating mutually exclusive investment proposals, these methods will
give different rankings. The best project is the one, which adds the most, among available
alternatives, to the shareholders wealth. The NPV method by its very definition, will
always select such projects.

6.4.2 Interrelation between Payback, Net Present Value, IRR and
Profitability Index

We have seen
Cost of the Project
Payback period =
Annual cost saving/Inflows

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