# NPV vs IRR vs PB vs PI vs ARR

Every firm has to make several investment decisions in its life. Investment decisions are the firm’s decision to invest its funds, most efficiently, into long-term assets. The firms do so because it expects the investment to provide them with some benefits over a single or a series of years. Decisions like launching an advertisement campaign or a research and development program have serious implications on the firm because they involve huge money. Hence, a firm must decide on its investment only after properly evaluating it. Let’s understand NPV vs IRR vs PB vs PI vs ARR and will discuss the difference between them.

Several investment criteria, which help a firm evaluate investment proposals, are in practice. The most important ones among them are:

1. Net Present Value
2. Internal Rate of Return
3. Payback Period
4. Profitability Index
5. Accounting Rate of Return

## Net Present Value (NPV)

Net present value is a method that is used to determine the present value of all future cash flows that the investment will generate. It then compares the present value of all future cash inflows with the value of the cash outflows to decide if the investment should be made or not. Suppose that a project costs you \$1,000 (cash outflow), and it will generate you future cash flows of \$500, \$300, and \$800 in the first, second, and third years respectively. Also, suppose that you expect a minimum of 8% return per annum from this investment, considering its risk. So, Net Present Value will be the difference between cash outflow and the present value of the future cash inflows. We can calculate it as:

NPV = [\$500/ (1 + 0.08)1 + \$300/(1 + 0.08)2 + \$800/(1 + 0.08)3] – \$1,000

= \$1335.23 – \$1,000

= \$335.23

Considering that the Net Present Value of the investment is positive, the investment proposal should be accepted since this means that the investment is providing more returns than the expected return of 8% per annum. Had the NPV been negative, we would have rejected the proposal since it would have meant that the investment is providing returns lesser than 8% per annum.

## Internal Rate of Return (IRR)

The concept of the Internal Rate of Return is quite simple to understand. Suppose that you invest \$10,000 in a bank today, and you will be getting \$10,800 after one year. In this case, IRR will be:

IRR = \$10,800 – \$10,000 / \$10,000

= \$800 / \$10,000

= 8%

IRR, in other words, is the rate of return at which the Net Present Value of an investment becomes zero.

## Payback (PB)

Payback is the number of years it requires to recover the original investment which is invested in a project. If the project generates constant annual cash inflows, we can calculate the payback period as:

Payback = Initial Investment / Annual Cash Inflow

## Profitability Index (PI)

The profitability index is the ratio between the present value of all future cash flows and the initial cash outflow of the investment. If the ratio is greater than 1, then according to the PI method, the company should accept the project since it is providing returns that are greater than the minimum return you expect (used in calculating present value).

PI = Present Value of Future Cash Flows / Initial Cash Outlay

## Accounting Rate of Return (ARR)

The accounting rate of return is also known as the return on investment (ROI). ARR does not consider the time value of money. It is calculated by dividing the income which the company expects to generate from its investment and the cost of that investment.

ARR = (Investment Income / Cost of Investment) * 100

## Differences between the NPV vs IRR vs PB vs PI vs ARR

Quiz on NPV vs IRR vs PB vs PI vs ARR.  MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

### 2 thoughts on “NPV vs IRR vs PB vs PI vs ARR”

1. Its is very easy to understand and nicely explained in one place

2. 