Ques No 1-Difference between NVP and IRR?

BASIS FOR COMPARISON NPV and IRR

1: Meaning the total of all the present values of cash flows (both positive and negative) of a
project is known as Net Present Value or NPV.
2: Decision Making. It makes decision making easy.
3: What it represents? Surplus from the project.
4: Rate for reinvestment of intermediate cash flows Cost of capital rate.
5: Variation in the cash outflow timing will not affect NPV.
IRR:
1. IRR is described as a rate at which the sum of discounted cash inflows equates discounted
cash outflows.
2: It does not help in decision making.
3: Point of no profit no loss (Breakeven point)
4: Internal rate of return.
5: Will show negative or multiple IRR.

Ques No 2-What are the critical factors to be observed while making capital
budgeting under capital rationing?

WHAT IS CAPITAL BUDGETING?

Capital budgeting is a company’s formal process used for evaluating potential expenditures or
investments that are significant in amount. It involves the decision to invest the current funds for
addition, disposition, modification or replacement of fixed assets. The large expenditures include
the purchase of fixed assets like land and building, new equipment’s, rebuilding or replacing
existing equipment’s, research and development, etc. The large amounts spent for these types of
projects are known as capital expenditures.
FACTORS AFFECTING CAPITAL BUDGETING: _Working Capital, Availability of Funds
,Structure of Capital undefined, Capital Return Availability of Funds ,Management decisions
undefined, Need of the project Availability of Funds ,Accounting methods undefined
,Government policy Availability of Funds, Taxation policy undefined ,Earnings Availability of
Funds ,Lending terms of financial institutions undefined, Economic value of the project.
Capital rationing decision
In a situation where the firm has unlimited funds, capital budgeting becomes a very simple
process. In that, independent investment proposals yielding a return greater than some
predetermined level are accepted. But actual business has a different picture. They have fixed
capital budget with large number of investment proposals competing for it. Capital rationing
refers to the situation where the firm has more acceptable investments requiring a greater amount
of finance than that is available with the firm. Ranking of the investment project is employed on
the basis of some predetermined criterion such as the rate of return. The project with highest
return is ranked first and the acceptable projects are ranked thereafter.

Ques No 3-What is the Criterion for judging the worth of investment in the
capital budgeting technique based on the profitability index? What is its
value? When its NVP is a) Zero b) negative) positive? Also indicate the
relationship between IRR and cost of capital?

The criteria for judging the worth of investment in capital budgeting technique based on
profitability index are present value of future expected cash flow and initial investment. The
Profitability index is calculated by dividing the present value of future expected cash flows by
the initial investment amount in the project. If profitably index is greater than 1.0 is deemed as a
good investment, with higher values corresponding to more attractive.
The profitability index (PI), alternatively referred to as value investment ratio (VIR) or profit
investment ratio (PIR), describes an index that represents the relationship between the costs and
benefits of a proposed project. It is calculated as the ratio between the present value of future
expected cash flows and the initial amount invested in the project. Profitability index helps in
ranking investments and deciding the best investment that should be made. PI greater than one
indicates that present value of future cash inflows from the investment is more than the initial
investment, thereby indicating that it will earn profits. IRR is a discount rate at which NPV
equals 0. So, IRR is a discount rate at which the present value of cash inflows equals the present
value of cash outflows. If the IRR is higher than the required return, we should invest in the
project. If the NPV of a project or investment is positive, it means that the discounted present
value of all future cash flows related to that project or investment will be positive, and therefore
attractive.
Relationship between IRR and cost of capital
IRR <cost of Capita [Reject the investment from the cash flow perspective. Other factors could
be important. ] IRR= cost of capital [provide a minimum return probably reject from the cash
flow perspective. Other factors could be important.] IRR> cost of capital [screen in for further
analysis. Other investment may provide better return and capital should other rationed other
factor could be important.
Question4 For the most investment decisions that firm faces net present value
is either a superior decision criteria or is at least as good as completing
technique. In what investment situation is the probability index is better than
the present value?

The profitability index is an alternative of the net present value. Profitability Index would be
bigger than 1.0 if the net present value appears positive. Otherwise, it would be negative. These
two calculations are crucial to determine whether the project would succeed or fail. Net Present
Value is considered as one of the most desirable types of evaluation, analysis, and selection of
great investments. However, we should note that we have to be very careful when estimating
cash flows, since an incorrect cash flow estimation may lead to deceptive NPV.
Another thing you should take into account is that the discount rate is the same for both cash
inflows and outflows, and the thing here is that the rates are different when lending or borrowing.
Still, NPV is the first and foremost measure of investment evaluation, compared to other
methods such as determining the rate of return, payback period, internal rate of return (and
Profitability Index). In fact, profitability index is related to Net Present Value, where the value
presents an absolute measure, and the index presents a relative measure.
Proprietors raise investors’ wealth by welcoming projects that have a higher value than they
actually cost, that has a positive expected Net Present Value. Sometimes the investment can be
postponed and choose a time that is the most suitable for investment, and thus improve the cash
flow.
If the NPV of a project or investment is positive, it means that the discounted present value of all
future cash flows related to that project or investment will be positive, and therefore attractive. A
single IRR can't be used in this case. ... If a discount rate is not known, or cannot be applied to a
specific project for whatever reason, the IRR is of limited value. In cases like this, the NPV
method is superior. If a project's NPV is above zero, then it's considered to be financially
worthwhile.