Investment Criteria

The key steps involved in determining whether a project is

worthwhile or not are:
 Estimate the costs and benefits of the project
 Assess the riskiness of the project
 Calculate the cost of capital
 Compute the criterion of merit and judge whether the
project is good or bad
It is proposed to discuss the criteria of merit, referred to
as investment criteria or capital budgeting techniques.
A familiarity with these criteria facilitates an easier
understanding of costs and benefits, risk analysis, and
cost of capital.
The important investment criteria, classified into two
broad categories- discounting and non-discounting
Investment Criteria

1. Discounting Criteria :
 Net Present Value
 Benefit Ratio
 Internal Rate of Return
2. Non-discounting Criteria:
 Pay Back Period
 Accounting Rate of Return
Net Present Value
The NPV of a project is the sum of the present values of all
the cash flows that are expected to occur over the the life of
the project. The general formula for NPV is:

n t
NPV = Σ C t / (1 + r ) – Initial Investment
t =1
 Where C t = cash flow at the end of year t
n = life of the project
r = discount rate
The NPV represents the net benefit over and above the
compensation for time and risk. Hence the decision rule
associated with the NPV criterion is:
Accept the project if the NPV is positive
Reject the project if the NPV is negative
( If the NPV = 0 it is the matter of indifference)
Properties of NPV Rule
a) The value of a firm can be expressed as the sum of the
present value of projects in place and the NPV of future
projects.
Value of a firm = Σ Present value of projects + Σ NPV of
expected future projects
The first term on RHS captures the value of assets in place
and the second term the value of growth opportunities.
(b) When a firm terminates an existing project which has a
negative NPV based on its expected future cash flows,
the value increases by that amount. Likewise, when a
firm undertakes a new project that has a negative NPV,
value of the firm decreases by that amount.
(c) When a firm divests itself of an existing project, the
price at which the project is divested affects the value
of the firm. If the price is greater/lesser than the present
value of the anticipated cash flows of the project the
value of the firm will increase/decrease with the
divestiture.
(d) When a firm takes on a new project with a positive
NPV, its effect on the value of the firm depends on
whether its NPV is in line with expectation.
(e) When a firm makes an acquisition and pays a price in
excess of the present value of the expected cash flows
from the acquisition it is like taking on a negative NPV
 project and hence will diminish the value of the firm.
NPV calculation Permits Time-varying Discount Rates
The formula used is as under:

n t t
NPV = Σ C t / Π(1 + r j )– Initial Investment
t =1 j=1

Where C t = cash flow at the end of year t

n = life of the project
r j = one period discount rate
To illustrate for a 5-year project, the following date is available.

Discount rate(%) 14 15 16 18 20
Investment -12,000
Cash flow 4,000 5,000 7,000 6,000 5,000
Calculate the Net Present Value.
 The PV of each of the cash flows can be calculated as under:
PV of C1 = 4,000/ 1.14 = 3509
PV of C2 = 5,000/(1.14*1.15) = 3814
PV of C3 =7,000/(1.14*1.15*1.16) = 4603
PV of C4 = 6,000/(1.14*1.15*1.16*1.18) = 3344
PV of C5 = 5,000/(1.14*1.15*1.16*1.18*1.20) = 2322
PV of project =17592
NPV of project = 17592 – 12,000 = Rs. 5592
Modified NPV
The standard NPV method is based on the assumption that
the intermediate cash flows are reinvested at a return equal
to the cost of capital. However, when this assumption is not
valid, the reinvestment rates are applicable to intermediate
cash flows need to be defined for calculating the modified
NPV as under:
Step : Calculate Terminal value of the project’s cash
inflows using the explicitly defined reinvestment rate(s).
n n-1
TV = Σ CF t ( 1 + r’)
t=1
Where TV = terminal value of the project’s cash inflows
CF t = cash inflow at the end of year t
r’ = reinvestment rate applicable to the cash inflows of
the project
 Step 2 : Determine the modified NPV
n
NPV* = TV / (1 +r ) – I
Where NPV* = Modified NPV
TV = terminal value
r = cost of capital
I = investment outlay
Calculate modified NPV:
Investment outlay Rs. 1,10,000
Year Cash inflows
1 31,000
2 40,000
3 50,000
4 70,000
Cost of capital 10 % and reinvestment rate is 14%
 3 2
TV = 31000( 1.14)+40,000(1.14) +50,000(1.14) +70,000
= Rs. 2,24,911
4
NPV* = TV/(1.10) – 1,10,000
4
= 2,24,911/(1.10) – 1,10,000
= Rs. 43,614
Benefit Cost Ratio
Benefit Cost Ratio BCR = PVB
I
Net Benefit Cost Ratio NBCR = PVB – I = BCR - 1
I
Where PVB = present value of benefits
I = initial investment
 Year Cash flow
1 Rs. (1,00,000)
2 25,000
3 40,000
4 50,000
5 40,000
6 60,000
If the cost of the capital is 12%, calculate BCR and NBCR
BCR = 25,000+ 40,000+50,000+40,000 +60,000 = 1.273
(1.12) (1.12)² (1.12)³ (1.12)4 (1.12)5
1,00,000
NBCR = BCR – 1 = 0.273 Rule is as under:
When BCR or NBCR Rule is
>1 >0 Accept
=1 =0 Indifferent
<1 <0 Reject
Internal Rate of Return
The IRR of a project is the discount rate which makes its
NPV equal to zero. Alternatively, it is the discount rate which
equates the present value of future cash flows with the initial
investment.
n t
Investment = Σ C t / (1 + r )
t =1
Where C t = cash flow at the end of year t
n = life of the project
r = internal rate of return (IRR)
In the NPV calculation we assume that the discount rate
(cost of capital) is known and determine the NPV. In IRR
calculation, we set the NPV to zero and determine the
discount rate that satisfies this condition.
The calculation of r involves a process of trial and error.
(iterative process). Suppose for some project of an
initial investment of Rs. 1,00,000 we get at r=15%,
 we get RHS= 1,00,802 and at r= 16%, RHS = 98,641, we
find that the value of r lies between 15 % and 16 %. For
a refined estimate of r we use the following procedure.
1. NPV (for15%) = 802 and NPV (for16%) = -1,359.
2. Sum of the absolute value of both = 802 + 1,359 = 2,162
3. Calculate the ratio of the smaller discount rate,
802 / 2161 = 0.37
4. Add the number to the smaller discount rate
15 +0.37 = 15.37%
The rule is: if the IRR is greater than the cost of capital,
then accept the project and if less than the cost of capital
reject the project.
NPV and IRR
Both rules lead to identical decision subject to:
1. The cash flows of the project must be conventional i.e.
the initial investment is negative and the subsequent
cash flows are positive.
2. The project must be independent.
Modified IRR
Despite NPV’s conceptual superiority, managers seem to
prefer IRR over NPV because IRR is intuitively more
appealing as it is a percentage measure.There is a
percentage measure that overcomes the shortcomings of
regular IRR which is called the modified IRR or MIRR.
How to calculate MIRR?
Step 1: Calculate the present value of costs (PVC) of the
project, using the cost of capital (r) as the discount rate.
n t
PVC = Σ Cash outflow t / ( 1 + r )
t =0
Step 2: Calculate the terminal value(TV) of the cash inflows
n n–t
TV = Σ Cash inflow t ( 1 + r )
t =0
 Step 3: Obtain MIRR by solving the following equation:
n
PVC = TV / I + MIRR )
Consider the case where the expected cash flows of
a project is as follows:
Year Cash flows
0 Rs. (1,000)
1 (1,200)
2 (600)
3 (250)
4 2,000
5 4,000
If the cost of the capital is 12 %, calculate the project’s MIRR.
Solution:
PV = 1,000 + 1200/1.12 +600/(1.12)²+ 250(1.12)³
= 1,000 +1071 +478 +223 =2772
TV = 2,000 (1.12) + 4,000 = 6240
 To obtain IMRR,
2772 = 6240 / ( 1+MIIR)ª where a = 5
MIRR = (2.251)1/5 – 1 =

Evaluation
MIRR is superior to the regular IRR in two ways:
1. It assumes that project cash flows are reinvested at the
cost of capital whereas the regular IRR assumes that
project cash flows are reinvested at the project’s own IRR.
Since reinvestment at cost of capital is more realistic than
reinvestment at IRR, MIRR reflects better the true
profitability of a project.
2. The problem of multiple rates does not exist with MIRR.
Conclusion:
1. If the mutually exclusively projects are of the same size,
NPV and MIRR lead to the same decision irrespective of
variations in life.
 2. If the mutually exclusive projects differ in size, there is
a possibility of conflict.
Pay Back Period
 PBP is the length of time required to recover the initial
cash outlay on the project.
 According to PBP criterion, the shorter the PBP, the
more desirable the project. Firms using this criterion
generally specify the maximum acceptable PBP.
 PBP is widely used as it is simple, both in concept and
application, and it is a rough and ready method for
dealing with risk. However, it has serious limitations:
it does not consider the time value of money; it ignores
cash flows beyond the PBP; it is a measure of capital
recovery, not profitability.
 To overcome the limitation of not considering time
value of money, the discounted payback period has
been suggested, as discussed below.
Discounted Pay Back Period
Example:
Year Cash Flow Discounting Present Value Cumulative Net
Factor @ 10% Cash Flow after
Rs. Discounting
0 –10,000 1.000 Rs. –10,000 –10,000
1 3,000 0.909 2,727 - 7,273
2 3,000 0.836 2,478 - 4,795
3 4,000 0.751 3,004 - 1,791
4 4,000 0.683 2,732 941
5 5,000 0.621 3,105
6 2,000 0.565 1,130
7 3,000 0.513 1,539
It can be observed that the PBP is 3 years, while
discounted PBP lies between 3 and 4 years
Accounting Rate of Return
The accounting rate of return, also called the average rate of
return, is defined as
Profit after tax
Book Value of the investment
 The accounting rate of return has certain virtues:
1. It is simple to calculate.
2. It is based on accounting information which is readily
available and familiar to businessmen.
3. It considers benefits over the entire life of the projects.
However, there are serious shortcomings;
1. It is based upon accounting profit, not cash flow.
2. It does not take into account the time value of money.
3. It is internally inconsistent.

Assessment of Various Methods

All the five basic methods of evaluation have been
discussed at length. We shall now do a summary assessment
of these methods on the basis of certain theoretical and
practical considerations.
 NPV BCR IRR PBP ARR

Theoretical /Practical considerations

1. Does the method consider Yes Yes Yes No ?
all cash flows?
2. Does the method discount Yes Yes No No No
cash flows at the
opportunity cost of funds
3. Does the method satisfy Yes No No ? ?
the principle value of
additivity?
4. From a set of mutually Yes No No ? ?
exclusively projects, does
the method choose the
project which maximizes
shareholder wealth?
5. Is the method simple? Yes Yes Yes Yes Yes
6. Can the method be used No No No Perhaps Yes
with limited information?
7. Does the method give a No Yes Yes No Yes
relative measure?
Project Appraisal International Practice
 In the U.S. , the internal rate of return, net present value,
accounting rate of return, and pay back period are the most
popular methods of project appraisal.
 Japanese firms appear to rely mainly on two kinds of analysis
(i) One year return on investment analysis, and (ii) residual
investment analysis.
Residual investment analysis is similar to the discounted
payback analysis. This analysis shows how long it will take
for the residual investment in the project to become zero
after taking into account the time vale of money. This
period is conceptually equal to the discounted pay back
period.