Preference Decisions - The Ranking of Investment Projects

 When making capital budgeting decisions, projects are first screened into acceptable
and unacceptable groups.
 Projects in the acceptable group are then ranked in order of preference. Either the
internal rate of return method or the net present value method can be used to make
this ranking.

1. Internal Rate of Return Method. When using the internal rate of return method to rank
competing investment projects, the preference rule is: The higher the internal rate of return,
the more desirable the project.

Here’s how to calculate IRR:

Let's say a company is considering investing $50,000 in a new project. The project is
expected to generate annual profits as follows over its five-year life:

• Year 1: $10,000
• Year 2: $12,000
• Year 3: $15,000
• Year 4: $18,000
• Year 5: $20,000

First, we calculate the average annual profit:

Average Annual Profit = (Total Profit over 5 years) / (Number of vears)

Average Annual Profit = ($10,000 + $12,000+ $15,000 + $18,000 + $20,000) / 5
Average Annual Profit = $75,000 / 5
Average Annual Profit = $15,000

Next, we compute the Rate of Return:

Rate of Return = (Average Annual Profit) / (Initial Investment)
Rate of Return = $15,000 / $50,000
Rate of Return = 0.3 or 30%
2. Net Present Value Method. Every project with a positive net present value is acceptable.
However, if investment funds are limited, there needs to be some method of ranking
acceptable projects in order of how well they utilize the available funds. If projects are not
equal in size and there are limited investment funds, then it is necessary to compute each
project's profitability index.

Here’s how to calculate NPV:

Consider getting the Net Present Value of an investment worth $50,000 in the next 5 years. The
investment will be sold for $25,000 in the 5th year.

Initial Investment: $50,000

C+: 5 years
Cf: 18,000
Df: 5%

Y CF DF 5% PV
1 18,000 0.952 17,136

2 18,000 0.907 16,326

3 18,000 0.864 15,552

4 18,000 0.823 14,814

5 43,000 0.784 33,712

= 97,540

NPV = 97,540 – 50,000

= 47,540
 The formula for the profitability index (PI) is:

PI = Present value of cash inflows / Investment required

When using the profitability index, the preference rule is: the higher the profitability index, the
more desirable the project.

Ranking Investment Proposals

Several methods are commonly used to rank investment proposals, including : NPV, IRR, PI,
payback period, and ARR

KEY POINTS

* The higher the NV, the more attractive the investment proposal.
* The higher a project's IRR, the more desirable it is to undertake the project.
* As the value of the profitability index increases, so does the financial attractiveness of the
proposed project.
* Shorter payback periods are preferable to longer payback periods.
* The higher the ARR, the more attractive the investment.

The most valuable aim of capital budgeting is to rank investment proposals. To choose the most
valuable investment option, several methods are commonly used:

Net Present Value (NPV):

NPV can be described as the "difference amount" between the sums of discounted:cash inflows
and cash outflows. In the case when all future cash flows are incoming, and the only outflow of
cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase
price (which is its own PV). The higher the NPV, the more attractive the investment proposal.
NPV is a central tool in discounted cash flow(DCF) analysis and is a standard method for using
the time value of money to appraise long-term projects. Used for capital budgeting and widely
used throughout economics, finance, and accounting, it measures the excess or shortfall of cash
flows, in present value terms, once financing charges are met.
Internal Rate of Return (IRR)
The internal rate of return on an investment or project is the "annualized effective
compounded return rate" or "rate of return" that makes the net present value (NPV as
NET*1/(1+IRR)^year) of all cash flows (both positive and negative) from a particular investment
equal to zero.

IRR calculations are commonly used to evaluate the desirability of investments or projects. The
higher a project's IRR, the more desirable it is to undertake the project. Assuming all projects
require the same amount of up-front investment, the project with the highest IRR would be
considered the best and undertaken first.

Profitability Index (PI)

It is a useful tool for ranking projects, because it allows you to quantify the amount of value
created per unit of investment. The ratio is calculated as follows:

Profitability index = PV of future cash flows / Initial investment

As the value of the profitability index increases, so does the financial attractiveness of the
proposed project. Rules for selection or rejection of a project:

* If PI > 1 then accept the project

* If PI < 1 then reject the project

Accounting Rate of Return (ARR)
The ratio does not take into account the concept of time value of money. ARR calculates the
return, generated from net income of the proposed capital investment. The ARR is a percentage
return. Say, if ARR = 7%, then it means that

The project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or
greater than the required rate of return, the project is acceptable. If it is less than the desired
rate, it should be rejected. When comparing investments, the higher the ARR, the more
attractive the investment.

Basic formula:

ARR = Average profit / Average investment

Where: Average investment = (Book value at beginning of year 1 + Book valueat end of user
life) / 2
Payback Period
Payback period intuitively measures how long something takes to "pay for itself.

" All else being equal, shorter payback periods are preferable to longer payback periods.
Payback period is widely used because of its ease of use despite the recognized limitations: The
time value of money is not taken into account.

The payback period method is a simple way to evaluate the profitability of a capital investment
project. It measures how long it takes for the project to recover its initial cost from the cash
flows it generates. However, what if the cash flows are uneven or change signs multiple times
over the project's life? How do you calculate the payback period in such cases? In this article,
you will learn how to deal with these challenges and some limitations of the payback period
method.

The Payback Period Method.

The payback period is defined as the length of time that it takes for an investment project to
recoup its initial cost out of the cash inflows that it generates.

When the net annual cash inflow is always the same, the payback period can be computed as
follows:

Example: If you invest $10,000 in a project that generates $2,000 per year, the payback
period is 5 years.

When cash flows associated with an investment project are erratic or uneven, the payback
period is computed by subtracting the net cash flow from the unrecovered investment each
year until the unrecovered investment is zero.

The basic criticisms of the payback period method are that it does not measure the profitability
of an investment and it does not consider the time value of money. However, it does have value
in situations where the useful life of the project is short and difficult to predict.
Payback and uneven cash flow
- Payback period analysis is a method used to evaluate the time it takes to recover the initial
investment in a project or investment. When dealing with uneven cash flows, you'll need to
consider each cash flow separately and calculate the cumulative cash flow until it equals or
exceed the initial investment. The payback period is then the time it takes for this cumulative
cash flow to occur.

Here’s how to calculate payback for uneven cash flow :

Initial investments: 20,000

Year 1 Cash Flow: 5,000

Year 2 Cash Flow: 7,000
Year 3 Cash Flow: 4,000
Year 4 Cash Flow: 8,000

To compute the payback period:

*Calculate the cumulative cash flow for each year:

Year 1: 5,000
Year 2:( 5,000+7,000) =12,000
Year 3:(12,000 +4,000)=16,000
Year 4:(16,000+8,000)=24,000

*Identify the year in which the cumulative cash flow equals or exceeds the initial investment:
The cumulative cash flow exceeds the initial investment of 20,000 in Year 3.
*To find the exact payback period, interpolate:

Payback period =
Year before recovery + ( unrecovered cost at the beginning of the year / Cash flow during the
year )

Payback period: 2+ (4,000/8,000)

= 2.5 years

So, the payback period for this investment is 2.5 years.

The present value (PV) of a series of cash flows
The present value (V) of a series of cash flows refers to the current worth of a stream of future
cash flows, discounted back to the present time using a specified discount rate.

For example, let's say you expect to receive 1000 at the end of each year for the next five years.
If the discount rate is 5%, you would calculate the present value of each cash flow and then
sum them up.

PV of year 1 cash flow = 1000 / (1 + 0.05)^1 = 952.38

PV of year 2 cash flow = 1000 / (1 + 0.05)^2 = 907.03
PV of year 3 cash flow = 1000 / (1 + 0.05) ^3 = 863.84
PV of year 4 cash flow = 1000 / (1 + 0.05) ^4 = 822.70
PV of year 5 cash flow = 1000 / (1 + 0.05) ^5 = 783.53

Then, you add these present values together:

PV = Php. 952.38 + Php. 907.03 + Php. 863.84 + Php. 822.70 +
Php. 783.53 = Php. 4329.48

So, the present value of receiving Php. 1000 at the end of each year for the next five years, with
a discount rate of 5%, is Php 4329.48.