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Unit 10: Measuring Project Profitability




          exist for an investment that has a negative NPV because the initial cash outflow will never be  Notes
          recovered.  When making a business case for sustainable investments, project managers  seek
          projects with the shortest possible discounted payback period.

          10.6.3 Profitability Index

          The ratio between a cash outflow on an investment and its prospective payoff is its profitability
          index, also referred to as profit investment ratio, benefit-cost ratio and value investment ratio.
          This is a capital budgeting technique that is used to grade an investment by assessing its benefit-
          cost ratio. Twelve percent of companies used the profitability index capital budgeting technique,
          among  the least  frequently used of capital budgeting methods, according to  a 2002  survey
          conducted by John Graham and Campbell Harvey of Duke University.

          10.6.4 Internal Rate of Return

          The internal rate of return, or IRR, is a capital budgeting method used to evaluate the potential
          growth of a project. Like the NPV capital budgeting technique, the IRR methodology is a time-
          adjusted measurement of the profitability of an investment. IRR is a good tool for comparing
          the profitability and sustainability of different investment opportunities.

          Self Assessment

          State True or False:
          11.  The discounted payback period is a capital budgeting technique used to calculate  the
               number of years it will take an investment or project to break even.
          12.  The ratio between a  cash outflow on  an investment and its prospective payoff is  its
               profitability index, also referred to as profit investment ratio.
          13.  The accounting rate of return, or ARR, is a capital budgeting method used to evaluate the
               potential growth of a project.

          14.  The ratio between a  cash outflow on  an investment and its prospective payoff is  its
               profitability index, also referred to as profit investment ratio.
          15.  When making a business case for sustainable investments, project managers seek projects
               with the shortest possible discounted payback period.

          10.7 Summary

              As a cost means a different thing to different people therefore, it is obvious that profitability
               would also be sensitive to these variations.
              Payback period in capital budgeting refers to the period of time required for the return on
               an investment to “repay” the sum of the original investment.

              Accounting rate of return or simple rate of return is the ratio of the estimated accounting
               profit of a project to its average investment.

              NPV can be described as the “difference amount” between the sums of discounted: cash
               inflows and cash outflows.
              The Internal Rate of Return (IRR) or Economic Rate of Return (ERR) is a rate of return used
               in capital budgeting to measure and compare the profitability of investments.





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