Capital budgeting decision

II. Graphical method.

ACCEPTANCE CRITERIA

Accept investment whose IRR>RRR and reject those investment, whose IRR

The higher the IRR the better the project in case all projects have IRR>RRR.

III. When IRR=RRR the project may be accepted depending on the objectives of the investor

• ADVANTAGES
• I. It recognizes the concepts of time value of money.
• II. It uses cash flows which is consistent with the objectives of wealth maximization.
• III. It considers the cash flow over the entire life of the project.
• IV. It has psychological appeal to the users because of the percentage figure.
• V. It helps one to look for the particular rate of return that will make the investment break-even.
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• DISADVANTAGES
• I. One may fail to get the exact rate that equates the PV of benefits (cash inflow) to the PV of cost (cash outflows).
• II. There are situation when one obtains multiple internal rates of returns.
• III. It is the most difficult one to compute.
• IV. Where projects differ (all have different cash outlay), it yields conflicting results with the NPV methods.
• N.B: where one has to choose between NPV and IRR, NPV should be considered because it is superior.

PROFITABILITY INDEX METHOD OR BENEFIT COST RATIO

This is the ratio of the present value of cash inflows to present value of cash outflow. It is given by

PI=

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ACCEPTANCE CRITERIA

• If the P>1 it implies that the ∑PV of cash inflow is greater than ∑PV of cash outflow therefore, the project should be accepted.
• If PI=1 it implies that the project pays back what was invested. Depending on the aim of the project and the objectives of the investor it may be accepted. 
• If PI<1 it implies that ∑PV of cash inflows is less than ∑PV of cash out-flow and the NPV is negative. Therefore the project should be rejected.