When capital is limited and the projects from which to choose are not mutually exclusive, the decision as to which project should receive money first is made using the Profitability Indexes of the different proposed projects. The Profitability Index is a variation of the benefit/cost ratio. It represents the ratio of the benefits (present value of net cash inflows) to the costs (net initial investment). The Profitability Index enables us to compare (or rank) the benefit/cost ratios of different sized investments, since the Profitability Index expresses profitability on a percentage basis rather than a total dollar amount basis. It is very useful when we must compare multiple investments that are of different investment amounts, the projects are not mutually exclusive, and we need to prioritize them.
The Payback Method is used to determine the number of periods that must pass before the net after-tax cash inflows from the investment will equal (or "pay back") the initial investment cost. The Payback Method is a screening method of capital budgeting analysis, meaning that it can be used to determine whether an investment is worthwhile or not. However, it is not a means to rank acceptable projects. Furthermore, the Payback Period does not use discounted cash flow techniques, and it ignores any profits from the project that occur after the initial investment has been recouped.
The Accounting Rate of Return is a ratio of the amount of increased book income to the required investment. Since this method uses accrual accounting income, it includes depreciation. It does not take into account the time value of money, so it is less useful than the discounted cash flow methods of capital budgeting.
The IRR is the discount rate at which the NPV of an investment will be equal to 0, i.e., the discount rate at which the present value of the expected cash inflows from a project equals the present value of the expected cash outflows. If this rate is higher than the required rate of return, the investment is acceptable. If this rate is lower than the required rate of return, the investment should not be made. IRR is a good screening method, meaning it is useful for evaluating whether or not an investment should be made. However, it is not useful for ranking projects when capital is rationed, because it cannot be used to determine which project(s) among all of the acceptable projects will be most profitable. A project with a very small initial investment may have a high IRR, but its NPV may be lower than the NPV of a project requiring a larger initial investment.
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