Ø Discounted Cash Flow (DCF) Technique NPV, IRR and PI are the

discounted cash flow (DCF) criteria for appraising the worth of an investment
project.
Ø Net Present Value (NPV) method is a process of calculating the present value
of the project’s cash flows, using the opportunity cost of capital as the discount
rate, and finding out the net present value by subtracting the initial investment
from the present value of cash flows.
Under the NPV method, the investment project is accepted if its net present
value is positive (NPV > 0). The market value of the firm’s share is expected to
increase by the project’s positive NPV. Between the mutually exclusive projects,
the one with the highest NPV will be chosen.
NPV methods account for the time value of money and are generally consistent
with the wealth maximisation objective.
Ø Internal Rate of Return (IRR) is that discount rate at which the project’s net
present value is zero. Under the IRR rule, the project will be accepted when its
internal rate of return is higher than the opportunity cost of capital (IRR > k).
 IRR methods account for the time value of money and are generally consistent
with the wealth maximisation objective.
Ø NPV and IRR NPV and IRR give same accept-reject results in case of
conventional independent projects. Under a number of situations, the IRR rule
can give a misleading signal for mutually exclusive projects. The IRR rule also
yields multiple rates of return for non-conventional projects and fails to work
under varying cost of capital conditions. Since the IRR violates the value-
additivity principle; since it may fail to maximise wealth under certain
conditions; and since it is cumbersome, the use of the NPV rule is recommended.
Ø Profitability index (PI) is the ratio of the present value of cash inflows to
initial cash outlay. It is a variation of the NPV rule. PI specifies that the project
should be accepted when it has a profitability index greater than one (PI > 1.0)
since this implies a positive NPV.
Ø NPV and PI A conflict of ranking can arise between the NPV and PI rules in
case of mutually exclusive projects. Under such a situation, the NPV rule should
be preferred since it is consistent with the wealth maximisation principle.
Ø Payback is the number of years required to recoup the initial cash outlay of an
investment project. The project would be accepted if its payback is less than the
standard payback. The greatest limitations of this method are that it does not
consider the time value of money, and does not consider cash flows after the
payback period.
Ø Discounted Payback considers the time value of money, but like the simple
payback it also ignores cash flows after the payback period. Under the conditions
of constant cash flows and a long life of the project, the reciprocal of payback can
be a good approximation of the project’s rate of return.
Ø Accounting Rate of Return is found out by dividing the average profit after-
tax by the average amount of investment. A project is accepted if its ARR is
greater than a cut off rate (arbitrarily selected). This method is based on
accounting flows rather than cash flows; therefore, it does not account for the
time value of money. Like PB, it is also not consistent with the objective of the
shareholders’ wealth maximisation.
Ø Following table provides a summary of the features of various investment
criteria.
SUMMARY OF INVESTMENT CRITERIA
I. Discounted Cash Flow Methods
1. Net present value (NPV): The difference between PV of cash flows and PV of
cash outflows is equal to NPV; the firm’s opportunity cost of capital being the
discount rate.
 C1 C2 C3 Cn 
NPV =  + + + ... +  − C0
 (1 + k ) (1 + k) 2
(1 + k)3
(1 + k)n 
n Ct
NPV = ∑ t
− C0
t =1 (1 + k)

Acceptance rule
• Accept if NPV > 0 (i.e., NPV is positive)
• Reject if NPV < 0 (i.e., NPV is negative)
• Project may be accepted if NPV = 0
 Merits Demerits
• Considers all cash flows. • Requires estimates of cash flows which is a
tedious task.
• True measure of profitability. • Requires computation of the opportunity cost
of capital which poses practical difficulties.
• Based on the concept of the time • Sensitive to discount rates.
value of money.
• Satisfies the value-additivity
principle (i.e., NPV’s of two or
more projects can be added).
• Consistent with the share-
holders’ wealth maximisation
(SWM) principle.

2. Internal rate of return (IRR): The discount rate which equates the present
value of an investment’s cash inflows and outflows is its internal rate of
return.
  C1 C2 C3 Cn 
 + + + ... +  = C0
 (1 + r) (1 + r)
2
(1 + r)3
(1 + r)n 
n
Ct
NPV = ∑ − C0 = 0
t =1 (1 + r ) t
Acceptance rule
• Accept if IRR > k
• Reject if IRR < k
• Project may be accepted if IRR = k
Merits Demerits
• Considers all cash flows. • Requires estimates of cash flows which is a
tedious task.
• True measure of profitability. • Does not hold the value-additivity principle
(i.e., IRRs of two or more projects do not add)
• Based on the concept of the time • At times fails to indicate correct choice between
value of money. mutually exclusive projects.
• Generally, consistent with wealth • At times yields multiple rates.
maximisation principle. • Relatively difficult to compute.
3. Profitability index (PI): The ratio of the present value of the cash flows to the
initial outlay is profitability index or benefit-cost ratio:
PV of Annual Cash Flows
PI =
Initial investment
n
Ct
∑
t =1 (1 + k) t
PI =
C0
Acceptance rule
• Accept if PI > 1.0
• Reject if PI < 1.0
• Project may be accepted if PI = 1.0
 Merits Demerits
• Considers all cash flows. • Requires estimates of the cash flows which
is a tedious task.
• Recognises the time value of • At times fails to indicate correct choice between
money. mutually exclusive projects.
• Relative measure of profitability.
• Generally consistent with the
wealth maximisation principle.

II. Non-Discounted Cash Flow Criteria

Acceptance rule
• Accept if PB < standard payback
• Reject if PB > standard payback
 Merits Demerits
• Easy to understand and compute • Ignores the time value of money.
and inexpensive to use.
• Emphasises liquidity. • Ignores cash flows occurring after the
payback period.
• Easy and crude way to cope with risk. • Not a measure of profitability.
• Uses cash flows information. • No objective way to determine the
standard payback.
• No relation with the wealth maximisation
principle.

5. Discount payback: The number of years required in recovering the cash outlay
on the present value basis is the discounted payable period. Except using
discounted cash flows in calculating payback, this method has all the
demerits of payback method.
6. Accounting rate of return (ARR): An average rate of return found by dividing
the average net operating profit [EBIT (1 – T )] by the average investment.
Average net operating profit after tax
ARR =
Average investment
 Acceptance rule
• Accept if ARR > minimum rate
• Reject if ARR < minimum rate
Merits Demerits
• Uses accounting data with which • Ignores the time value of money
executives are familiar.
• Easy to understand and calculate. • Does not use cash flows.
• Gives more weightage to future • No objective way to determine the
receipts. minimum acceptable rate of return.

Net present value (NPV) method is the most superior investment criterion as it is always
consistent with the wealth maximisation principle.