CAPITAL BUDGETING

Capital budgeting refers to the process of determining which long-term investments a

company should undertake. These investments typically involve large sums of money and are
expected to generate benefits over an extended period, often several years or more. Capital
budgeting involves evaluating and selecting projects that involve significant expenditures,
such as building a new factory, purchasing new equipment, or investing in research and
development.

OBJECTIVES OF CAPITAL BUDGETING

1. Maximizing Shareholder Wealth: One of the foremost goals of capital budgeting is

to maximize the wealth of the shareholders by investing in projects that generate
positive returns and enhance the overall value of the firm. This involves selecting
projects that offer the highest potential for increasing the company's stock price and
providing adequate returns to shareholders.

2. Enhancing Long-Term Profitability: Capital budgeting aims to identify investment

opportunities that contribute to the long-term profitability of the company. By
investing in projects that generate sustainable revenue streams and cost savings over
time, firms can improve their financial performance and competitiveness in the
market.

3. Allocating Scarce Resources Efficiently: Capital budgeting helps in allocating

limited financial resources (such as funds, time, and manpower) among competing
investment alternatives. By evaluating the potential risks and returns associated with
different projects, companies can make informed decisions about where to allocate
their resources to achieve the best possible outcomes.

4. Managing Risk: Another objective of capital budgeting is to manage risk effectively

by assessing the uncertainties associated with investment projects. This involves
conducting risk analysis, considering factors such as market conditions, regulatory
changes, technological advancements, and project-specific risks to minimize potential
losses and maximize returns.

5. Supporting Strategic Goals: Capital budgeting aligns investment decisions with the
strategic objectives of the company. By investing in projects that align with the
company's long-term vision, goals, and core competencies, firms can ensure that their
investments contribute to sustainable growth and competitive advantage.

6. Ensuring Capital Adequacy: Capital budgeting also aims to ensure that the
company maintains adequate capital resources to support its ongoing operations,
expansion plans, and future investment opportunities. By balancing investments in
growth-oriented projects with the need to preserve financial stability, firms can
sustainably manage their capital structure and liquidity position.
 IMPORTANCE OF CAPITAL BUDGETING

1. Long-term Investment Decisions: Capital budgeting helps businesses make

informed decisions regarding long-term investments in projects and assets. These
investments typically involve substantial funds and have far-reaching implications for
the company's future profitability and growth.

2. Optimal Resource Allocation: It assists in allocating financial resources efficiently

among competing investment opportunities. By evaluating and selecting projects
based on their potential returns and risks, capital budgeting ensures that resources are
directed towards the most promising ventures, maximizing overall returns for the
company.

3. Risk Management: Capital budgeting involves assessing the risks associated with
investment projects, allowing businesses to identify and mitigate potential threats to
their financial health. Through risk analysis and evaluation, companies can make
more informed decisions and implement strategies to manage uncertainties
effectively.

4. Enhanced Profitability: Effective capital budgeting leads to the selection of projects

that contribute to the company's long-term profitability. By investing in projects with
positive net present values (NPV) or high internal rates of return (IRR), businesses
can generate sustainable revenue streams and increase their bottom line over time.

5. Strategic Alignment: Capital budgeting aligns investment decisions with the

strategic objectives and goals of the company. It ensures that investments support the
company's long-term vision, core competencies, and competitive advantage, thereby
fostering sustainable growth and development.

6. Shareholder Value Maximization: By selecting projects that maximize shareholder

wealth through increased stock prices, dividends, or other financial returns, capital
budgeting directly contributes to maximizing shareholder value. It helps companies
focus on investments that create value for their shareholders over the long term.

7. Capital Structure Management: Capital budgeting decisions also influence the

company's capital structure by determining the mix of debt and equity financing
required for investment projects. By considering the cost of capital and financial
leverage, businesses can optimize their capital structure to minimize financing costs
and maximize returns to shareholders.

8. Compliance and Accountability: Proper capital budgeting processes ensure

compliance with regulatory requirements and financial reporting standards. It also
 promotes transparency and accountability in decision-making by providing a
systematic framework for evaluating and documenting investment proposals.

TECHNIQUES OF CAPITAL BUDGETING

Traditional Techniques of Capital Budgeting

Traditional techniques of capital budgeting refer to the methods used by businesses to
evaluate and make decisions regarding potential long-term investments in projects or assets.
These techniques help determine whether a particular investment is financially viable and will
generate returns that justify the initial expenditure.

Merits:

1. Simplicity: Traditional techniques are often straightforward to understand and

calculate, making them accessible to managers and decision-makers without extensive
financial training.
 2. Clarity of Decision Criteria: Each technique provides a clear decision criterion (e.g.,
positive NPV, IRR exceeding the cost of capital) that helps in evaluating and
comparing investment opportunities.

3. Focus on Cash Flows: These techniques primarily focus on cash flows, which are
essential for assessing the actual financial impact of an investment.

4. Consideration of Time Value of Money: NPV, IRR, and discounted payback period
explicitly consider the time value of money by discounting future cash flows,
providing a more accurate assessment of investment profitability.

5. Quantitative Analysis: Traditional techniques allow for quantitative analysis,

enabling businesses to compare investments based on financial metrics and make
data-driven decisions.

Demerits:

1. Ignoring Non-Financial Factors: Traditional techniques often overlook qualitative

and non-financial factors such as strategic alignment, market trends, and
environmental impact, which can be critical in real-world decision-making.

2. Assumption of Certainty: Many traditional techniques assume certainty regarding

future cash flows, discount rates, and project durations, which may not hold true in
uncertain or dynamic business environments.

3. Subjectivity in Cost of Capital: Determining the appropriate discount rate (cost of

capital) for NPV and IRR calculations can be subjective and may lead to inconsistent
results across projects.

4. Potential Misinterpretation: The use of single-point estimates for cash flows and
discount rates may lead to misinterpretation of results, especially when dealing with
complex projects or uncertain environments.

5. Focus on Short-Term Returns: Techniques like Payback Period may prioritize

projects with shorter payback periods, leading to the neglect of potentially more
profitable long-term investments.

6. Ignoring Reinvestment Rate: Traditional techniques often assume that cash flows
generated by the project can be reinvested at the same rate as the discount rate, which
may not reflect reality.
 1. PAYBACK PERIOD

The payback period method is one of the simplest techniques used in capital budgeting to
evaluate investment projects. It measures the time required for an investment to generate cash
flows sufficient to recover the initial investment cost. Here's how the payback period method
works:

1. Calculate Initial Investment: Determine the initial cash outlay required for the
investment project. This includes the cost of acquiring assets, installation expenses,
and any other associated costs.

2. Estimate Cash Flows: Estimate the cash inflows expected to be generated by the
investment project over its lifetime. These cash flows may include revenues, cost
savings, or other benefits attributable to the project.

3. Calculate Cumulative Cash Flows: Calculate the cumulative cash flows over time
by adding up the cash inflows received each period until the total equals or exceeds
the initial investment.

4. Identify Payback Period: Determine the time it takes for the cumulative cash flows
to equal the initial investment. The payback period is the point at which the initial
investment is fully recovered.

The formula to calculate the payback period is:

Importance of Payback Period Method:

1. Simplicity: The payback period method is straightforward and easy to understand,

making it accessible even to those without extensive financial expertise. It provides a
simple measure of liquidity and helps in quickly assessing the time it takes to recover
the initial investment.

2. Focus on Liquidity: It emphasizes liquidity by focusing on the time it takes for an

investment to recoup its initial outlay. This can be particularly important for
businesses with limited capital or short-term liquidity concerns.

3. Risk Assessment: The payback period method provides insight into the risk
associated with an investment by indicating how long it takes to recover the initial
investment. Shorter payback periods generally indicate lower risk, as the investment
recovers its cost more quickly.
4. Decision Making: It can serve as a screening tool for investment projects, helping
companies prioritize projects with shorter payback periods. This can be especially
useful when a company needs to choose among several potential projects with limited
resources.

Limitations of Payback Period Method:

1. Ignoring Time Value of Money: The payback period method does not consider the
time value of money, meaning it ignores the fact that a dollar received today is worth
more than a dollar received in the future due to factors such as inflation and the
opportunity cost of capital.

2. Incomplete Measure: It only considers the time it takes to recover the initial
investment and does not account for cash flows beyond the payback period. As a
result, it provides an incomplete picture of a project's profitability and may lead to the
neglect of long-term benefits.

3. Subjectivity in Cutoff Period: The selection of the cutoff period for payback (e.g.,
three years, five years) is often arbitrary and subjective, leading to inconsistencies in
decision-making. Different managers may have different preferences for payback
periods, leading to potential biases.

4. Ignoring Cash Flow Timing: The payback period method treats cash flows
uniformly, ignoring the timing of cash inflows and outflows within each period.
Projects with uneven cash flow patterns may be incorrectly evaluated or compared.

5. Risk and Uncertainty Ignored: It does not consider the risk or uncertainty
associated with future cash flows, such as changes in market conditions, technology
obsolescence, or regulatory factors. Projects with shorter payback periods may appear
more favorable, even if they entail higher risk.
 2. The Accounting Rate of Return (ARR) method

The Accounting Rate of Return (ARR) method, also known as the Average Rate of Return or
the Return on Investment (ROI) method, is a simple capital budgeting technique used to
evaluate the profitability of an investment project. Unlike other methods such as Net Present
Value (NPV) or Internal Rate of Return (IRR), the ARR method does not consider the time
value of money. Instead, it focuses solely on accounting profits generated by the investment
relative to the initial investment cost. Here's how the ARR method works:

Calculation of Accounting Rate of Return (ARR):

The ARR is calculated as the average annual accounting profit generated by the investment
project divided by the average investment cost, expressed as a percentage. The formula for
ARR is as follows:

Where:

 Average Net Profit = Average annual net income generated by the project, typically
calculated as the average of the net income over the project's useful life.

 Average Investment = Average initial investment cost of the project, often calculated
as the initial investment cost + Salvage Value divided by 2.

Steps to Calculate ARR:

1. Determine Accounting Profits: Calculate the annual accounting profits generated by

the investment project, usually by subtracting annual depreciation expenses, operating
costs, and taxes from annual revenues.

2. Calculate Average Annual Accounting Profit: Find the average of the annual
accounting profits over the project's useful life.

3. Determine Initial Investment Cost: Determine the initial cost of the investment
project, including capital expenditures, installation costs, and any other associated
expenses.
 4. Calculate Average Investment Cost: Divide the initial investment cost by the
project's useful life to find the average investment cost per year.

5. Compute ARR: Divide the average annual accounting profit by the average
investment cost and multiply by 100 to express the result as a percentage.

Interpretation of ARR:

 If the ARR is greater than the required rate of return or the company's minimum
acceptable rate of return, the project is considered acceptable.

 If the ARR is less than the required rate of return, the project may be rejected.

Advantages of ARR:

1. Simple to Calculate: The ARR method is straightforward and easy to understand,

making it accessible to non-financial managers.

2. Uses Accounting Data: It relies on accounting profits, which are readily available
from financial statements.

3. Helps in Comparison: It allows for easy comparison of different investment projects

based on their accounting profitability.

Limitations of ARR:

1. Ignores Time Value of Money: ARR does not consider the time value of money,
which can lead to incorrect investment decisions.

2. Doesn't Account for Cash Flows: It ignores cash flows, focusing solely on
accounting profits, which may not reflect the economic reality of the investment.

3. Subject to Accounting Policies: ARR can be influenced by accounting policies such

as depreciation methods and tax treatments, leading to inconsistent results.

4. Doesn't Consider Project Duration: It assumes that the project's cash flows and
accounting profits are uniform over its useful life, which may not be the case in
practice.
 DISCOUNTED CASH FLOW (DCF) TECHNIQUES OF CAPITAL BUDGETING

The discounted cash flow (DCF) technique is a financial valuation method used to estimate
the value of an investment based on its expected future cash flows. It involves discounting
those cash flows back to their present value using a discount rate.

Merits:

1. Incorporates the Time Value of Money: DCF takes into account the principle of the
time value of money, recognizing that a dollar received in the future is worth less than
a dollar received today due to factors like inflation and opportunity cost.

2. Focuses on Cash Flows: DCF focuses on the cash flows generated by an investment,
which is a more reliable measure of value than accounting profits, as it accounts for
actual cash movements.

3. Flexibility: It can be applied to a wide range of investment types, including stocks,

bonds, real estate, and capital projects, making it a versatile valuation tool.

4. Allows Sensitivity Analysis: DCF enables sensitivity analysis by adjusting key

variables such as discount rate or growth rate, helping to understand the impact of
changes in assumptions on the valuation.

5. Long-Term Perspective: DCF provides a long-term perspective, allowing investors

to assess the potential value of an investment over its entire lifespan.

Demerits:

1. Sensitivity to Assumptions: DCF relies heavily on assumptions about future cash

flows, discount rates, and terminal values, which can be subjective and uncertain,
leading to potential inaccuracies in valuation.

2. Complexity: DCF analysis can be complex, requiring detailed financial modeling and
understanding of financial concepts such as discounting, perpetuity, and terminal
value calculation.

3. Dependence on Forecasting: DCF valuation heavily depends on accurate forecasting

of future cash flows, which can be challenging, especially for projects with uncertain
or volatile cash flow patterns.

4. Ignoring Market Dynamics: DCF may overlook market dynamics and qualitative
factors such as competitive landscape, regulatory changes, and technological
advancements, which can significantly impact the future cash flows of an investment.
 5. Difficulty in Choosing Discount Rate: Selecting an appropriate discount rate (cost of
capital) for discounting future cash flows is subjective and requires estimation,
leading to potential biases and errors in valuation.

Net Present Value

Net Present Value (NPV) is a financial metric used to evaluate an investment's profitability
by comparing the present value of cash inflows with the present value of cash outflows. It
helps determine whether a project or investment will add value to a business or organization.

The concept of NPV is based on the time value of money, which states that money available
today is worth more than the same amount in the future due to its potential earning capacity.
By discounting future cash flows to their present value, NPV takes into account the
opportunity cost of investing money in a project.

Advantages of Net Present Value

1. Time Value of Money Consideration: NPV considers the time value of money by
discounting future cash flows back to their present value. This means it accounts for
the fact that money received or spent in the future is worth less than money received
or spent today due to factors like inflation and opportunity cost.

2. Accounting for Risk: NPV allows for the incorporation of risk by using a discount
rate that reflects the risk associated with the investment. This makes NPV a more
comprehensive method compared to techniques like payback period or accounting
rate of return, which do not explicitly consider risk.

3. Considers All Cash Flows: NPV considers all cash inflows and outflows associated
with a project over its entire life. This includes initial investment, operating cash
flows, salvage value, and any other relevant cash flows. By considering the entire
cash flow stream, NPV provides a more accurate picture of the project's profitability.

4. Decision Criteria: NPV provides a clear decision rule: if the NPV is positive, the
project is expected to generate more value than it costs, and thus it's considered
acceptable. If the NPV is negative, the project is not expected to generate sufficient
returns to cover its costs and should be rejected.

5. Allows for Comparison: NPV facilitates the comparison of different investment

opportunities by providing a common metric (present value of cash flows). This
allows managers to prioritize projects and allocate resources efficiently based on their
potential to create value for the company.
6. Considers the Entire Life of the Project: NPV takes into account the full life cycle
of the project, allowing decision-makers to assess long-term implications and avoid
making decisions based solely on short-term gains.

Disadvantages of Net Present Value

1. Complexity in Estimating Discount Rate: Calculating the appropriate discount rate
to use in NPV analysis can be challenging. The discount rate should reflect the
project's risk, but estimating this rate accurately can be subjective and may require
assumptions that could affect the reliability of the NPV calculation.

2. Assumption of Reinvestment Rate: NPV assumes that cash flows generated by the
project can be reinvested at the discount rate used in the analysis. However, in reality,
it may be difficult to find investment opportunities with the same rate of return,
leading to potential inaccuracies in NPV calculations.

3. Difficulty in Evaluating Intangible Benefits: NPV focuses on quantifiable cash

flows, which may overlook intangible benefits such as brand value, employee morale,
or strategic positioning. These intangible benefits are often difficult to quantify and
may not be fully captured in NPV analysis.

4. Inflexibility with Mutually Exclusive Projects: NPV may not provide clear
guidance when evaluating mutually exclusive projects (projects where selecting one
precludes the selection of others). In such cases, NPV may favor projects with higher
absolute NPV, even if they have lower NPV per dollar invested, potentially leading to
suboptimal decision-making.

5. Ignoring Real Options: NPV assumes that investment decisions are irreversible,
ignoring the value of flexibility or options that may arise during the project's life. Real
options such as the option to expand, delay, or abandon a project have value but are
not explicitly considered in NPV analysis.

6. Sensitivity to Input Variables: NPV is sensitive to changes in input variables such as

cash flow estimates, discount rate, and project life. Small changes in these variables
can significantly impact the calculated NPV, making the analysis vulnerable to errors
or manipulation.

7. Bias towards Short-Term Projects: Since NPV discounts future cash flows, projects
with shorter payback periods may appear more favorable than longer-term projects,
even if the latter have higher overall profitability.
 PROFITABILITY INDEX
The Profitability Index (PI) measures the ratio between the present value of future cash flows and
the initial investment. The index is a useful tool for ranking investment projects and showing the
value created per unit of investment.

Therefore:

 If the PI is greater than 1, the project generates value and the company may want to
proceed with the project.
  If the PI is less than 1, the project destroys value and the company should not proceed with
the project.

 If the PI is equal to 1, the project breaks even and the company is indifferent between
proceeding or not proceeding with the project.

The higher the profitability index, the more attractive the investment.

Advantages of Profitability Index

1. Relative Measurement of Profitability: The PI provides a relative measure of

profitability by comparing the present value of cash inflows to the initial
investment required. This allows for the comparison of different projects
regardless of their scale or absolute cash flows.

2. Consideration of Time Value of Money: Similar to NPV, the Profitability

Index takes into account the time value of money by discounting future cash
flows back to their present value. This ensures that cash flows received in the
future are appropriately weighted against cash flows received today.

3. Clear Decision Criterion: Like NPV, the Profitability Index provides a clear
decision rule: if the index is greater than 1, the project is expected to generate
more value than it costs, making it acceptable. If the index is less than 1, the
project is not expected to generate sufficient returns to cover its costs and
should be rejected.

4. Useful in Capital Rationing Situations: When a company faces capital

constraints and cannot undertake all projects with positive NPVs, the
Profitability Index can help prioritize projects by identifying those that offer
the highest return relative to the investment required. This makes it a useful
tool in situations of capital rationing.

5. Ease of Interpretation: The Profitability Index is straightforward to interpret.

A value greater than 1 indicates that the project is expected to generate more
value than it costs, while a value less than 1 indicates the opposite. This
simplicity makes it accessible to managers and stakeholders who may not
have expertise in finance.

6. Complementary to NPV: The Profitability Index can be used in conjunction

with NPV analysis to provide additional insights into project profitability.
While NPV measures absolute profitability, the Profitability Index offers a
relative measure, helping managers prioritize projects and allocate resources
efficiently.
 Disadvantages of Profitability Index

1. Dependency on Discount Rate: Like NPV, the Profitability Index depends on

the discount rate used to discount future cash flows. Estimating the
appropriate discount rate can be challenging, and different discount rates may
lead to different PI values, potentially affecting the decision-making process.

2. Assumption of Reinvestment Rate: Similar to NPV, the Profitability Index

assumes that cash flows generated by the project can be reinvested at the
discount rate used in the analysis. However, in reality, reinvestment
opportunities may not always be available at the same rate, leading to
potential inaccuracies in PI calculations.

3. Difficulty in Comparing Projects with Different Lifespans: The Profitability

Index may not be suitable for comparing projects with different lifespans.
Since it only considers the present value of cash flows and initial investment,
projects with longer lifespans may have lower PI values due to the higher
initial investment, even if they offer higher total profitability over their entire
lifespan.

4. Limited Consideration of Risk: While the Profitability Index accounts for the
time value of money, it may not explicitly consider the risk associated with the
investment. Projects with similar PI values may have different risk profiles,
which are not reflected in the index, potentially leading to suboptimal
decision-making.

5. Potential Bias towards Larger Projects: The Profitability Index may favor
larger projects with higher absolute cash flows, as they tend to have higher PI
values. This bias may overlook smaller projects with shorter payback periods
or higher returns on investment, leading to missed opportunities for value
creation.

6. Ignorance of Project Scale: The Profitability Index does not account for the
scale of the project. It may not distinguish between projects that require
significantly different initial investments but offer similar returns.
Consequently, it may not provide a comprehensive assessment of the project's
profitability relative to its scale.
 7. Limited Consideration of Non-Monetary Factors: Like other quantitative
capital budgeting techniques, the Profitability Index may overlook qualitative
or non-monetary factors such as strategic alignment, environmental impact, or
social responsibility, which could be crucial considerations in investment
decisions.

Example: A company allocates $1,000,000 to spend on projects. The initial investment, present
value, and profitability index of these projects are as follows:
 Discounted Pay Back Period

The discounted payback period is a financial metric used to evaluate the time it takes for an
investment to generate enough cash flows to recover its initial investment, taking into
account the time value of money by discounting those cash flows. Unlike the regular
payback period, which does not consider the time value of money, the discounted payback
period considers the present value of future cash flows.

Merits:

1. Considers Time Value of Money: Unlike the traditional payback period, which
ignores the time value of money, the discounted payback period accounts for the
present value of future cash flows. This makes it a more accurate measure of an
investment's profitability.

2. Relatively Simple: The calculation of the discounted payback period involves

discounting future cash flows and comparing them to the initial investment. While it
requires some financial knowledge, it's generally straightforward compared to more
complex methods like net present value (NPV) or internal rate of return (IRR).

3. Provides Risk Assessment: By considering the time value of money, the discounted
payback period offers insights into the risk associated with an investment. Projects
with shorter discounted payback periods are generally less risky because they recover
the initial investment sooner.

Demerits:

1. Ignores Cash Flows Beyond Payback Period: Like the traditional payback period,
the discounted payback period focuses solely on the time it takes to recoup the initial
investment. It does not consider cash flows beyond the payback period, potentially
leading to an incomplete assessment of long-term profitability.

2. Dependent on Discount Rate: The choice of discount rate used in the calculation of
the discounted payback period can significantly impact the results. Different discount
rates may lead to different conclusions about the attractiveness of an investment,
making it somewhat subjective.

3. Doesn't Account for Reinvestment: The discounted payback period assumes that
cash flows received after the payback period are not reinvested, which may not reflect
real-world scenarios. Ignoring reinvestment opportunities can underestimate the true
profitability of an investment.

4. Doesn't Consider Profitability: While the discounted payback period indicates when
the initial investment is recovered, it doesn't provide information about the overall
profitability of the investment. An investment with a short payback period may still
have a low NPV or IRR, indicating poor profitability over the long term.
 Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is a financial metric used to evaluate the profitability of an
investment or project. It represents the discount rate at which the net present value (NPV) of
all cash flows from the investment equals zero. In simpler terms, it is the rate of return at
which the present value of cash inflows equals the present value of cash outflows.

Here's how IRR is calculated:

1. Calculate the present value of all cash inflows and outflows associated with the
investment. This involves discounting each cash flow back to its present value using
the IRR as the discount rate.
 2. Set up an equation where the sum of the present values of cash inflows equals the sum
of the present values of cash outflows.

3. Solve the equation to find the rate at which the NPV equals zero. This rate is the
Internal Rate of Return.

Internal Rate of Return (IRR)

DCF- C0 = 0

Advantages of Internal Rate of Return (IRR):

1. Ease of Comparison: IRR provides a single percentage figure that allows for easy
comparison between different investment opportunities. This makes it simpler for
decision-makers to evaluate and prioritize projects.

2. Time Value of Money: IRR takes into account the time value of money by
discounting future cash flows back to their present value. This makes it a more
accurate measure of profitability than simple payback period.

3. Reflects Investment Risk: Since IRR considers the timing and magnitude of cash
flows, it reflects the risk associated with an investment. Higher IRR implies higher
potential returns, which can be appealing to investors seeking higher-risk investments.

4. Flexible: IRR can be used for various types of projects or investments, regardless of
their size or duration. It is applicable to both short-term and long-term projects.

5. Considers Reinvestment Rate: IRR assumes that cash flows received from the
investment are reinvested at the same rate as the IRR itself. This makes it more
realistic than some other metrics.

Disadvantages of Internal Rate of Return (IRR):

1. Multiple IRRs: In some cases, a project may have multiple IRRs, making
interpretation challenging. This can occur when the project has alternating periods of
positive and negative cash flows.

2. Assumes Reinvestment Rate: While IRR assumes that cash flows are reinvested at
the same rate as the IRR, this might not be realistic in practice. The actual
reinvestment rate may vary, affecting the accuracy of the IRR calculation.

3. Ignorance of Scale: IRR does not consider the scale of investment. Two projects with
different cash flows and initial investments may have the same IRR, but vastly
different profitability in absolute terms.
4. No Clear Decision Criteria: While a higher IRR generally indicates a more desirable
investment, it doesn't provide a clear threshold for decision-making. It does not
consider the size or risk of the investment, so it should be used in conjunction with
other metrics.

5. Sensitive to Timing: IRR heavily depends on the timing of cash flows. A delay in
receiving cash flows can significantly impact the calculated IRR and may not
accurately reflect the project's true profitability.