The accounting rate of return and the net present value method may result in different investment decisions because they use different measurements. The net present value method uses cash flow, whereas the accounting rate of return uses accounting income. The net present value method uses discounted amounts, whereas the accounting rate of return does not.
The Profitability Index (PI) will always result in the same investment decision for a project as the net present value method because it is derived from the same figures as the net present value. The net present value is the present value of the project's future expected net cash inflows minus the present value of its expected net cash outflows. The profitability index is the present value of the project's future expected net cash inflows divided by the present value of its expected net cash outflows. If the NPV of the project is positive, the project's PI will be greater than 1. If the NPV of the project is zero, the project's PI will be exactly 1. If the NPV of the project is negative, the project's PI will be less than 1. Note that for a conventional project, the only net cash outflow will be the initial investment. However, not all projects are conventional projects, so the net present value of any project is the cumulative present value of all of its positive and negative net cash flows. And the profitability index of any project is the present value of its future expected net cash inflows divided by the present value of its expected net cash outflows. The denominator includes not only the net initial investment outflow but also the present value of any future expected net cash outflows.
The discounted payback method and the net present value method may result in different investment decisions because they measure different things. When the net present value method is used, a project is acceptable if the cumulative present value of all of the expected net cash flows from the project is positive. The discounted payback method uses the present value of expected future cash flows to calculate the payback period. Each year’s cash flow is discounted using an appropriate interest rate, and then those discounted cash flows are used to calculate the payback period. But the investment decision that results is dependent on the required payback period set by management and whether or not the project meets it, not on whether the project has a positive net present value.
When the net present value method is used, a project is acceptable if the cumulative present value of all of the expected net cash flows from the project is positive. The internal rate of return (IRR) method calculates the interest rate (i.e., the discount rate) at which the present value of expected cash inflows from a project equals the present value of expected cash outflows. That is the discount rate at which the NPV is equal to zero. The calculated IRR is then compared with the company's required rate of return (RRR) for the purpose of deciding whether the project is profitable enough to undertake. Although it is true that an IRR higher than the company's required rate of return would correlate with a positive net present value, the two methods may not always result in the same investment decision. A project may have a very high IRR, but the project may be a very small project, and its NPV, though positive, might not be as high as that of other projects under consideration. In a situation where capital rationing is being used, that smaller project might not be accepted due to its low NPV.
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