The IRR is the discount rate at which the NPV of an investment will be equal to 0. This is 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. IRR is used primarily to evaluate projects to determine whether or not they are acceptable. It is not usually used to rank projects.
When the projects under consideration are of different time periods or amounts of initial investments, the Profitability Index may provide different rankings than NPV would. If this occurs, the NPV rankings should be preferred over the PI rankings. However, that is not what this question is asking for. This question asks what method managers are most likely to use. Managers are usually not financial executives. The Profitability Index is a benefit/cost ratio that represents the ratio of the benefits (net cash inflows) to the costs (net cash outflows) of a project and as such, it is relatively easy for managers to understand. Thus, managers are most likely to choose among prospective investments based on their PIs.
The Profitability Index is a benefit/cost ratio that represents the ratio of the benefits (net cash inflows) to the costs (net cash outflows) of a project. Therefore, it enables ranking of the benefit/cost ratios of investments with different characteristics. When there are multiple independent investment opportunities, managers will usually select the project or projects that have the highest Profitability Index. However, this is not always the best way to choose prospective investments. When the projects under consideration are of different time periods or amounts of initial investments, the Profitability Index may provide different rankings than NPV would. If this occurs, the NPV rankings should be preferred over the PI rankings.
Companies use the Payback Method to determine the number of periods that must pass before the net after-tax cash inflows from an investment will equal (or “pay back”) the initial investment cost. The Payback Method and its variations are screening methods of capital budgeting analysis – meaning we are determining only whether or not this is a good investment. The Payback Method is not used to rank projects when capital is rationed.
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