Lecture 5: Capital Budgeting and Investment Rules (Part B)

Question 1

What is the Internal Rate of Return?

Answer 1

The generated return per year is called the project’s Internal Rate of Return (IRR).

Question 2

Should you choose an investment based on the internal rate of return?

Answer 2

The Bottom Line on IRR
Picking the investment opportunity with the largest IRR can lead to a mistake.

In general, it is dangerous to use the IRR in choosing between projects.

 Use NPV!

Question 3

How to choose a project based of the profitability index?

Answer 3

In the profitability index

independent projects: Choose those with PI > 0

For mutually exclusive projects: Choose the one with the highest PI

Question 4

What is the disadvantages of using the profitability index?

Answer 4

A drawback of the PI is that it does consider the size / scale of the investment

Example:
Project A: Investment cost = $1,000, NPV = $5,000  PI = 5
Project B: Investment cost = $100,000, NPV = $300,000  PI = 3

With PI we choose project A but it doesn’t make us wealthier (but project B does)