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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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