Methods of Evaluation of Investment Projects: NPV, IRR, Payback Period, Discounted Payback Period, PI

There are many methods of evaluation profitability of investment projects. All of these
methods have their own merits and demerits. Some of the methods which are used for
evaluation of investment projects are:
1. NPV (Net Present Value)
2. IRR (Internal Rate of Return)
3. Payback period
4. Discounted payback period
5. PI (Profitability Index)
NPV (Net Present Value)
NPV (Net present value) is present value of all cash flows (whether inflow or outflow).
Present value of cash flows is calculated at a predetermined rate (cost of capital).
Formula for NPV is given below:
NPV = Present value of cash inflows – Present value of cash outflows
IRR (Internal Rate of Return)
IRR (Internal rate of return) calculates the rate at which NPV is equal to zero. In other
words, rate at which present value of all cash flows (inflows and outflows) is equal to zero
is call Internal Rate of Return.
Mutually Exclusive Projects
In case of mutually exclusive projects, IRR and NPV may give different results. It means
IRR and NPV will prefer different projects. In this case, it become difficult to choose the
most profitable one. There are three kinds of problems faced when considering mutually
exclusive projects:
a. Size disparity problem
b. Time disparity problem
c. Unequal life span problem
Size disparity problem – It refers to the situation when the projects are of different
investment amount. For example, one project requires $100 whereas another project
requires $2000. In such situations, NPV and IRR both may give different results.
Let us understand using example:
Particulars Project A Project B
Initial investment $100 $2,000
Cash flow (at the
end of year 1)
$128 $2,500
NPV @ 10% $16.36 $272.73
IRR 28% 25%