PPT On IRR And PI

Group 5

Submitted To :- Mrs. Kangan Mam

Submitted By :- Pallavi (72111143)
Eknoor Singh (72111837)
Manjot Singh (72011732)
Class :- B.COM/H 5th
BCH 502-21: Financial Management – I
Batch :- 2021-2024

School Of Management Studies

 Contents :-
Definition Of Profitability Index(PI)
Uses
Practical Applications Of PI
Advantages Of PI
Limitations Of PI
Definition Of Internal Rate Of Return(IRR)
IRR V/S ROI
Practical Application Of IRR
Advantages Of IRR
Limitations Of IRR
Comparison Of IRR and PI
Examples
Conclusion
 Profitability Index(PI)
The Profitability Index is a ratio that measures the attractiveness of an investment project by
comparing the present value of cash inflows to the present value of cash outflows.
The index useful tool for ranking investment projects and showing the value created per unit
of investment.
Formula for calculating PI :-
PI = (PV of cash inflows)
Initial investment

Acceptance Rule:
PI>1 (accept)
PI<1(reject)
 What Is the Profitability Index Used
for?
The profitability index is used for comparison and contrast when a company has several
investments and projects it is considering undertaking.
The PI is especially useful when a company has limited resources and can't pursue all
potential projects, as it can be used to prioritize which projects to pursue first.
 Practical Applications Of PI :-
 Project Screening: The PI is useful for screening and prioritizing potential projects. Projects with PIs
greater than 1 are generally considered for further analysis, while those with PIs less than 1 may be rejected
or deprioritized.

 Portfolio Management: In the context of investment portfolios, the PI can help assess the relative
attractiveness of various investment opportunities, assisting in portfolio optimization.

 Public Infrastructure Investments: Government agencies use the PI to assess the economic viability of
public infrastructure projects, such as building highways, bridges, or airports.

 Environmental Projects: Organizations involved in environmental initiatives or sustainability projects can

use the PI to evaluate the financial feasibility of green investments.

 Nonprofit Sector: Nonprofit organizations can use the PI to assess the potential returns on social or
community projects and allocate resources efficiently.

 Capital Allocation Decisions: The PI can aid in making decisions about allocating resources or funds to
different business units, divisions, or projects within a company.
 Advantages Of PI :-
 Considers Time Value of Money: Like the Net Present Value (NPV), the Profitability Index takes into
account the time value of money by discounting future cash flows to their present value. This provides a more
accurate reflection of the project's potential profitability.

 Measures Efficiency of Capital Utilization: The PI helps assess the efficiency of capital utilization by
comparing the present value of cash inflows to the present value of cash outflows. A higher PI suggests more
efficient use of capital, as it generates more value per dollar invested.

 Straightforward Interpretation: The PI is a ratio, expressed as a number greater than or equal to 1. A PI

greater than 1 indicates that the project is expected to generate a positive return and is, therefore, attractive. A
PI less than 1 suggests that the project may not generate sufficient returns to justify the investment.

 Enhances Project Prioritization: When comparing multiple projects or investment opportunities, the PI
allows for easy prioritization. Projects with higher PIs are generally more attractive in terms of return relative
to their costs.

 Overcomes IRR's Limitations: Unlike the Internal Rate of Return (IRR), the Profitability Index does not
suffer from issues like multiple IRRs or inconsistent project rankings when comparing mutually exclusive
projects. It is more reliable in this regard.
 Limitations Of PI
 Disregards Project Scale: The PI doesn't consider the absolute size of the project or the magnitude of cash flows.
Consequently, it may favor smaller projects with high PIs over larger, more significant projects with slightly lower PIs. This
can lead to suboptimal allocation of resources. For example, a project with a PI of 1.2 and an initial investment of $10,000
will create $2,000 of value, while a project with a PI of 1.1 and an initial investment of $100,000 will create $10,000 of
value. Even though the second project has a lower PI, it may be more desirable for the business if it has more resources
and wants to maximize its total value.

Different Lives of Different Projects

PI of those projects cannot be compared, which have different lives.
E.g., project A has a useful life of 5 yrs, and Project B has a useful life of 8 years. PI of these 2 projects cannot be compared.

Ignorance of non-financial factors

A fourth drawback of using PI for capital budgeting is that it ignores the non-financial factors that may
influence the project selection. PI only focuses on the monetary returns of the projects, but not on the qualitative
aspects such as social, environmental, ethical, or strategic implications. For example, a project with a lower PI may
have a higher social or environmental impact, or may align better with the vision or mission of the business. Using
PI alone may overlook these factors and may result in suboptimal or unsustainable outcomes
*PRACTICAL QUESTION
1) Suppose we have three projects involving discounted cash flow of Rs.5,50,000, Rs75,000
and Rs 1,00,20,000 respectively. Suppose further at the sum of discounted cash inflows for
these projects are Rs. 6,50,000, Rs. 95,000 and Rs 1,00,30,000 respectively. Calculate the
desirability factors for the three project.
SOLUTION :-

PI = (PV of cash inflows)

Initial investment

the desirability factors for the three projects would be follows.

1. Rs. 6,50,000/5,50,000 = 1.18

2. Rs. 95,000/75,000 = 1.27

3. Rs. 1,00,30,000/1,00,20,000 =1.001

* 2) The initial cash outlay of the project is Rs. 1,00,000
and its generate cash flow of Rs. 20,000, Rs. 40,000, Rs.
60,000 and Rs. 80,000 in 4 years . Assume 10% Rate of
Discount . Calculate PI and Also suggest whether to
accept or reject a project.
SOLUTION :-

Year Cash flows PVF @10% PVCIF (2*3)

(present value
factor)
1 20,000 0.909 18,180

2 40,000 0.826 33,040

3 60,000 0.751 45,060

4 80,000 0.683 54,640

• Total PVCIF= 1,50,920 and Cost of Invt. 1,00,000

• 1,50,920 /1,00,000 =1.5092
• As PI is higher than 1, the project should be accepted.
 Internal Rate Of Return

The internal rate of return (IRR) measures the return of a potential investment. The
calculation excludes external factors such as inflation which is why it’s called internal.
IRR, which is expressed as a percentage, helps investors and business managers compare
the profitability of different investments or capital expenditures
IRR Acceptance rule
IRR>K (accept)
IRR<K (reject) K= Cost of Capital
 Formula
The formula and calculation used to determine this figure are as follows:
IRR=
where

L= low rate
H= high rate
NL= NPV at low rate
NH= NPV at higher rate
 How to Calculate IRR

1. The initial investment is always negative because it represents an outflow.

2. Each subsequent cash flow could be positive or negative, depending on the

estimates of what the project delivers or requires as a capital injection in the
future.

3. However, because of the nature of the formula, IRR cannot be easily calculated
analytically and instead must be calculated iteratively through trial and error or by
using software programmed to calculate IRR (e.g., using Excel).
 IRR vs. Return on Investment (ROI)

 ROI tells an investor about the total growth, start to finish, of the investment. It is not an annual rate

of return. IRR tells the investor what the annual growth rate is. The two numbers normally would be

the same over the course of one year but won’t be the same for longer periods of time.

ROI is the percentage increase or decrease of an investment from beginning to end. It is calculated by

taking the difference between the current or expected future value and the original beginning value,

divided by the original value, and multiplied by 100.

 Practical application Of IRR :-
 Project Selection: IRR is commonly used to evaluate and select investment projects. It helps in
identifying projects that are expected to generate a return greater than the cost of capital, making
them suitable for investment.

 Capital Budgeting: Businesses use IRR to assess the potential profitability of capital
expenditures, such as buying new equipment, opening new facilities, or launching new products.

 Real Estate Investment: IRR is employed in real estate to evaluate the financial feasibility of
property investments, including rental properties, land development, and commercial buildings.

 Mergers and Acquisitions (M&A): In M&A transactions, IRR can be used to assess the
potential returns of the deal, helping in decision-making and negotiations.
 Advantages of IRR :-
 Time-Value of Money Consideration: IRR takes into account the time-value of money by discounting cash
flows to their present value. This reflects the reality that a dollar received in the future is worth less than a
dollar received today.

 Measures Overall Project Attractiveness: IRR provides a single percentage figure that summarizes the
overall attractiveness of an investment project. It tells you the rate of return the project is expected to
generate.

 Comparative Analysis: IRR allows for easy comparison of different projects or investments. You can
compare the IRR of multiple projects to determine which one offers the best return relative to its cost.

 Consideration of Cash Flow Timing: IRR considers the timing of cash flows. Projects with quicker
payback periods are favoured because they return the initial investment sooner.
 Limitations Of IRR :-
 Multiple IRRs: One of the significant limitations of IRR is the possibility of multiple IRRs in some
cases. This occurs when the project's cash flows change direction (from positive to negative or vice
versa) more than once during its life. When multiple IRRs exist, it can be challenging to interpret which
rate to use.

 Misleading Investment Decisions: IRR assumes that all cash flows are reinvested at the IRR itself,
which may not be a realistic assumption. This can lead to misleading investment decisions, especially if
the reinvestment opportunities differ from the IRR.

 Limited Information about Project Size: IRR provides limited information about the scale or size of a
project. A project with a high IRR might be a small, low-impact project, while a project with a lower IRR
could be a large, high-impact one.
PRACTICAL QUESTION
Calculate IRR of an investment of Rs 1,36,000 @10% discount which
yield the following cash flows.

YEAR CF
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
SOLUTION
YEAR CF DISCONT @ PV DISCOUNT @ PV
10% 12%
0 (-1,36,000) 1 (-1,36,000) 1 (-1,36,000)
1 30,000 0.909 27,270 0.893 26,790
2 40,000 0.826 33,040 0.797 31,880
3 60,000 0.751 45,060 0.712 42,720
4 30,000 0.683 20,490 0.636 19,080
5 20,000 0.621 12,420 0.567 11,340
TOTAL 2,280 -4190

IRR= L+[NL/NL-NH *(H-L)]

= 10+[2,280/2,280-(-4190)*(12-10)]
= 10+0.70
= 10.70%
 Comparison Of IRR and
Basis
Definition
PI :-
Profitability index
The Profitability Index is a ratio
Internal rate of return
The internal rate of return
that measures the attractiveness of (IRR) measures the return of
an investment project by a potential investment
comparing the present value of
cash inflows to the present value of
cash outflows
Handling multiple Handles multiple changes better May face difficulties when
rates and is not subject to multiple irr dealing with unconventional
issues cfs patterns

Multiple project Allow comparison of different May lead to ambiguous

sized projects decision when comparing
mutually exclusive projects
of different scales.
interpretation PI>1 (accept) IRR>K (accept)
PI<1(reject IRR<K (reject)
 Real world examples of IRR and PI :-
Real Estate Investment:
 IRR: A real estate developer is considering investing in a new residential apartment complex. They calculate the IRR
to determine the annualized return on their investment over the property's expected holding period.
 PI: A real estate investment trust (REIT) evaluates the profitability of acquiring a portfolio of commercial properties.
The PI helps assess whether the acquisition will generate sufficient returns relative to the purchase price.

. Venture Capital Investment:

 IRR: A venture capital firm assesses the potential returns of investing in a startup company. The IRR is calculated to
understand the potential return on their investment if the startup is successful.
 PI: A group of angel investors evaluates an early-stage technology company. They use the PI to assess whether the
company's growth potential and expected exit strategy offer a favourable return on their investment.
 Conclusion :-
In conclusion, the Internal Rate of Return (IRR) and Profitability Index (PI) are valuable financial metrics used in capital
budgeting and investment analysis. Each metric offers distinct advantages and limitations, making them suitable for different
types of investment decisions:

Internal Rate of Return (IRR):

 IRR is a percentage representing the expected annualized return on an investment.
 It considers the time value of money, cash flow timing, and provides a hurdle rate for project selection.
 IRR is commonly used for project ranking, especially when comparing mutually exclusive projects.
 It may suffer from issues like multiple IRRs and inconsistent project rankings in some cases.
 IRR is a useful tool for assessing and selecting projects, especially when the goal is to maximize returns.

Profitability Index (PI):

 The PI is a ratio that compares the present value of cash inflows to the present value of cash outflows.
 It focuses on capital efficiency, offering insights into the project's attractiveness and its efficient use of capital.
 The PI is valuable for project screening, prioritization, and relative comparison, especially when projects have different scales
and cash flow patterns.
 It doesn't face the issues of multiple IRRs or inconsistent project rankings that can occur with IRR.
 The PI is a reliable metric for assessing project profitability, especially when the objective is to optimize resource allocation.