will take in to account the capital cost. It may be defined as the number of
years required to recover the investment from discounted net cash flows.
2.2 The pay back and the discounted pay back methods do not consider the
returns after the payback period. Therefore ranking the projects by using
these techniques may likely to be defective.
- Net Present Value
3.1 Here also the DCFT financial concept has to be used to convert the cash
inflows (including the salvage value) as well as cash outflows in terms of
the present value of money. The difference will be the NPV. The project
showing higher NPV will be ranked over the project showing lesser NPV.
- Internal Rate of Return
4.1 In a project estimation, one has to find out a discount factor at which
NPV=O, where the PV of returns is equal to PV of costs. The discount
factor at which the NPV=O the IRR exists. More than this, NPV<O
(negation) where PV of cost exceeds the PV of returns and the project is
liable to the rejected. If the NPV is >O (positive) where the PV of returns
exceeds the PV of costs, the project will be selected. To rank the projects,
the firms present discount factor based on the opportunity cost will be
taken as base. The gap between this discount factor and the IRR (Where
NPV=O) of each project will be compared on the positive side. The
project with higher gap will be ranked.
- Modified Internal rate of Return
5.1 In calculating IRR as shown on LU.2, the cash inflows will not used for
reinvestment. But in MIRR the cash inflows will be shown as reinvested.
- Profitability index (PI)
6.1 This is based upon the benefit-cost ratio. The PV of benefit per P.V. of
rupee (cost) will be determined. The higher the P.I., the higher the project
ranking. After looking into the various methods of ranking one may
prefer the NPV and IRR method to rank the capital investment projects.
IRR is even more preferable because it clearly shows the safety margin in
the form of gap between opportunity cost of firm and a discount factor at
which NPV=O. The bigger organizations or when stakes are very high, a
decision maker may like to employ all methods to reach conclusions.
