Differences between internal rate of return and profitability index

Accounting

What are some differences between IRR and PI?

Internal Rate of Return (IRR)

IRR is the method by means of which returns on investment are calculated. IRR reflects the value of money over a period of time. In short it explains returns on investments in terms of interest rates. It tells how much rise in interest rate is needed to completely remove any expectation of good returns on investment. When IRR is really high, it means your investment involves little risk. A low risk investment is always desired and you might feel like undertaking a project based on high IRR. However IRR is not always accurate and may give highly unrealistic picture. Since IRR doesn't really talk about actual returns, it is considered safer to opt for a project that gives realistic IRR instead of one that shows unbelievably high IRR. When there is no initial cash outflow, the IRR produced may actually be in thousands, showing that the project or action is completely safe and absolutely risk-free. For this reason, it is important to have some initial cash outflow involved in order to keep IRR realistic.

Profitability Index (PI)

The profitability Index is another method for finding out the future worth of a project. A project is accepted when PI is greater than I and rejected when it is less than one. In this method, present value of cash inflow is compared with initial investment. PI is thus the ratio of the present value of cash inflows to the investment initially made in a project and is closer to NPV approach. The simplest way to find out if PI would be greater than 1 or not is by checking the present value of cash flow: A positive value of cash flow will result in PI being positive too and if the value is negative, the PI would also be negative. PI method is also more commonly known as cash/benefit ratio.

Buying vs. Leasing

Buying or leasing an asset is an important decision and one that comes with its fair share of pros and cons. However it is seen that most firms prefer to lease assets instead of buying them which brings us to the question as to why leasing is preferred over buying. The few good reasons behind this decision are that a) leasing allows firms to use a certain asset for a fixed period of time without coming up with large amount of money as initial down payment or purchase amount. For example if a firm decides to lease a computer for three years, he will generally have to come up with a small amount that is paid regularly for as long as the asset is used. This removes the need to invest anything major initially. This gives a firm greater freedom to use its capital on other assets or in other areas of management.

The other reason is that buying means you will become owner of an asset that will become have become obsolete by the time the mortgage period ends. Even if you buy it paying full price upfront, still after few years, the asset will become obsolete anyways and will have to be replaced by a better and newer asset. This is where leasing helps again. For one it allows you to use an asset you don't own for a certain period of time and when it becomes obsolete, you can always lease another piece. In the case of computers for example, we know that new processors are introduced almost every year. This means that a Pentium 1 which was so famous just a few years back is now considered nothing but junk. People are now using Pentium 4 and eagerly waiting for even faster and better machines. In such cases, it is not wise to invest in assets and leasing appears to be a much better option.