Accounting What Are Some Differences Between IRR Term Paper

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Accounting

What are some differences between IRR and PI?

Internal Rate of Return (IRR)

IRR is the method by means of which returns on investment are calculated. IRR reflects the value of money over a period of time. In short it explains returns on investments in terms of interest rates. It tells how much rise in interest rate is needed to completely remove any expectation of good returns on investment. When IRR is really high, it means your investment involves little risk. A low risk investment is always desired and you might feel like undertaking a project based on high IRR. However IRR is not always accurate and may give highly unrealistic picture. Since IRR doesn't really talk about actual returns, it is considered safer to opt for a project that gives realistic IRR instead of one that shows unbelievably high IRR. When there is no initial cash outflow, the IRR produced may actually be in thousands, showing that the project or action is completely safe and absolutely risk-free. For this reason, it is important to have some initial cash outflow involved in order to keep IRR realistic.

Profitability Index (PI)

The profitability Index is another method for finding out the future worth of a project.

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A project is accepted when PI is greater than I and rejected when it is less than one. In this method, present value of cash inflow is compared with initial investment. PI is thus the ratio of the present value of cash inflows to the investment initially made in a project and is closer to NPV approach. The simplest way to find out if PI would be greater than 1 or not is by checking the present value of cash flow: A positive value of cash flow will result in PI being positive too and if the value is negative, the PI would also be negative. PI method is also more commonly known as cash/benefit ratio.

Which capital budgeting valuation method is most preferred? Why?

IRR is more popular method than Pi even though both come with their share of flaws. The main reason for its popularity is its simple calculation method which takes into account important indicators such as the cash flows and time value of money. It is considered easier and more reliable in certain situations provided some conditions are fulfilled. However it may not always be very reliable in….....

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