Chapter 8 Investment Criteria

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Outline
Net present value Benefit cost ratio

Internal rate of return

Urgency Payback period Accounting rate of return Assessment of various methods Investment evaluation in practice.

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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 criteria of merit and judge whether

the project is good or bad.

For pedagogic purposes, we find it more convenient to start with a discussion of the criteria of merit, referred to as investment criteria or capital budgeting techniques. A familiarity with these criteria will facilitate an easier understanding of costs and benefits, risk analysis, and cost of capital.
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INVESTMENT CRITERIA
INVESTMENT CRITERIA

DISCOUNTING CRITERIA

NON-DISCOUNTING CRITERIA

NET PRESENT VALUE

BENEFIT COST RATIO

INTERNAL RATE OF RETURN

PAYBACK PERIOD

ACCOUNTING RATE OF RETURN

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Net Present Value

n NPV = t=1

Ct Initial investment (1 + rt )t

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NET PRESENT VALUE

The net present value of a project is the sum of the present values of all the cash flows associated with it. The cash flows are discounted at an appropriate discount rate (cost of capital)

Year
0 1 2 3 4 5 Pros

Naveen Enterprises Capital Project Cash flow Discount factor Present value -100.00 1.000 -100.00 34.00 0.870 29.58 32.50 0.756 24.57 31.37 0.658 20.64 30.53 0.572 17.46 79.90 0.497 39.71 Sum = 31.96 Cons
Is an absolute measure and not a relative measure

Reflects the time value of money Considers the cash flow in its entirety Squares with the objective of wealth maximisation

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Properties of the NPV Rule NPVs are additive Intermediate cash flows are invested at cost of capital NPV calculation permits time-varying discount rates NPV of a simple project decreases as the discount rate increases.
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Rationale for the NPV Rule

Year 1 M R P E L Y X

Year 0 O G F H D Q S N

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Rationale for the NPV Rule

What do we find when we compare the three cases ? If you invest an amount equal to DF in real assets you reach the consumption frontier MN; if you invest an amount equal to DG in real assets you reach the consumption frontier PQ; if you invest an amount equal to DH in real assets you reach the consumption frontier RS. Clearly, investment of an amount equal to DF in real assets is the most desirable course of action

since it takes you to the highest consumption frontier.

Investment of an amount equal to DF in real assets, it may be emphasised, is also the investment which has the highest net

present value

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Modified NPV
The standard net present value method is based on the assumption that the intermediate cash flows are re-invested at a rate of return equal to the cost of capital. When this assumption is not valid, the re-investment rates applicable to the intermediate cash flows need to be defined for calculating the modified net present value

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Steps in Calculating Modified NPV

Step 1 Calculate the terminal value of the projects cash inflows using the explicitly defined reinvestment rate(s) which are supposed to reflect the profitability of investment opportunities ahead of the firm. n TV = CFt (1+r t)n-t t=1 Step 2 Determine the modified net present value TV

NPV*

=
(1+ r)n

- I

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Benefit Cost Ratio

PVB Benefit-cost Ratio : BCR = I PVB = present value of benefits I = initial investment To illustrate the calculation of these measures, let us consider a project which is being evaluated by a firm that has a cost of capital of 12 percent. Initial investment : Benefits: Year 1 Year 2 Year 3 Year 4 Rs 100,000 25,000 40,000 40,000 50,000

The benefit cost ratio measures for this project are: 25,000 (1.12) BCR = 100,000 Pros Measures bang per buck Cons Provides no means for aggregation
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40,000 (1.12)2

40,000 (1.12)3

50,000 (1.12)4 = 1.145 NBCR=BCR-1 = 0,145

Internal Rate of Return

Net Present Value

Discount rate

The internal rate of return (IRR) of a project is the discount rate that makes its NPV equal to zero. It is represented by the point of intersection in the above diagram
Net Present Value

Internal Rate of Return

Assumes that the net present value is zero Figures out the discount rate that makes net present value zero

Assumes that the discount rate (cost of capital) is known Calculates the net present value, given the discount rate

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Calculation of IRR
You have to try a few discount rates till you find the one that makes the NPV zero
Year Cash flow Discounting rate : 20% Discounting rate : 24% Discounting rate : 28%

Discount
factor 0 1 2 3 4 5 -100 34.00 32.50 31.37 30.53 79.90 1.000 0.833 0.694 0.579 0.482 0.402

Present
Value -100.00 28.32 22.56 18.16 14.72 32.12

Discount Present
factor 1.000 0.806 0.650 0.524 0.423 0.341 Value -100.00 27.40 21.13 16.44 12.91 27.25

Discount
factor 1.000 0.781 0.610 0.477 0.373 0.291

Present
Value -100.00 26.55 19.83 14.96 11.39 23.25

NPV = 15.88

NPV = 5.13

NPV = - 4.02

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Calculation of IRR
NPV at the smaller rate Smaller Bigger Smaller discount + X discount discount Sum of the absolute values of the rate rate rate NPV at the smaller and the bigger discount rates

5.13 24% + 5.13 + 4.02 28% - 24% = 26.24%

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Problems with IRR

Non-Conventional Cash Flows

Mutually Exclusive Projects Lending vs. Borrowing Differences between Short-term and Long-term Interest Rates

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Non-Conventional Cash Flows

C0 -160 C1 +1000 C2 -1000

TWO IRRs : 25% & 400% NPV

25%

400%

NO IRR :

C0 150

C1 -450

C2 375

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Mutually Exclusive Projects

C0

C1

IRR

NPV (12%) 7,857 16,964

P Q

-10,000 -50,000

20,000 75,000

100% 50%

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Lending vs Borrowing

C0 A -4000

C1 6000

IRR 50%

NPV (10%) 145

4000

-7000

75%

-236

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What Does IRR Mean?

There are two possible economic interpretations of internal rate of return : (i) The internal rate of return represents the rate of return on the unrecovered investment balance in the project. (ii) The internal rate of return is the rate of return earned on the initial investment made in the project.

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What Does IRR Mean?

To understand the nature of these interpretations, consider a project with the following cash flows. Year 0 1 2 3 Cash flow Rs.-300,000 0 417,000 117,000

The internal rate of return of this project is the value of r in the expression -300,000 0 417,000 117,000

0 =

(1+r)0 (1+r)1 (1+r)2 (1+r)3 The value of r which satisfies the above expression is 30 percent
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What Does IRR Mean?

This figure, according to the first interpretation of internal rate of return, reflects the rate of return on the unrecovered investment balance. The unrecovered investment balance is defined as : Ft = Ft-1 (1+r) + Ct

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What Does IRR Mean?

Unrecovered Investment Balance
Year Unrecovered investment Balance at the beginning Interest for the year Cash flow at the end of the year Ft-1 1 2 3 Rs.-300,000 Rs.-390,000 Rs.-90,000 Ft-1 (1+r) -90,000 -117,000 -27,000 Ct 0 417,000 117,000 Unrecovered investment balance at the end of the year Ft-1 (1+r) + Ct -390,000 -90,000 0

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What Does IRR Mean?

Now, let us consider the second interpretation according to which, the internal rate of return is the compounded rate of return earned on the initial investment, for the entire life of the project. This means that if a project involves an initial outlay of I, has an internal rate of return of r percent, and has a life of n years, the value of the benefits of the project, assessed at the end of n years, will be I(1+r)n . In our numerical example, where the initial investment is Rs.300,000, the internal rate of return of the project is 30 percent, and the life of the project is three years, the value of the benefits of the project, assessed at the end of three years, will be Rs.300,000 (1+0.30)3 = Rs.659,100. The second interpretation of internal rate of return is based on the assumption that the intermediate flows of the project are re-invested at a rate of return equal to the internal rate of return of the project.
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What Does IRR Mean?

Which economic interpretation should we put on internal rate of return ? Since it is often not possible for a firm to re-invest intermediate inflows at a rate of return equal to the projects internal rate of return, the first interpretation seems more realistic. Hence, we may view internal rate of return as the rate of return on the time-varying, unrecovered investment balance in the

project, rather than the compounded rate of return on the initial

investment. This point deserves to be understood because the notion of internal rate of return generally creates the impression

that it is the rate of return earned on a sustained basis on the

initial investment over the life of the project.
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Modified IRR
0
-120

1
-80

2
20

3
60

4
80

5
100

6
120

-69.6 r =15% PVC = 189.6

PV = of TV NPV

189.6

r=15% 115 105.76 r =15% 91.26 r =15% 34.98 r =15% Terminal value (TV) = 467 MIRR = 16.2%

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Payback Period
Payback period is the length of time required to recover the initial outlay on the project Naveen Enterprises Capital Project Year Cash flow Cumulative cash flow 0 -100 -100 1 34 - 66 2 32.5 -33.5 3 31.37 - 2.13 4 30.53 28.40 Pros Simple Cons Fails to consider the time value of money Ignores cash flows beyond the payback period

Rough and ready method for dealing with risk Emphasises earlier cash inflows

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Accounting Rate of Return

The accounting rate of return, also referred to as the average rate of return on investment, is a measure of profitability which relates income to investment, both measured in accounting terms. Since income and investment can be measured variously, there can be a very large number of measures for accounting rate of return. The measures that are employed commonly in practice are :
Average income after tax A : Initial investment Average income after tax B : Average investment Average income after tax but before interest C : Initial investment
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Average income after tax but before interest D :

Average investment

Average income before interest and taxes

:
Initial investment Average income before interest and taxes

Average investment
Total income after tax but before depreciation Initial investment

:
(Initial investment / 2) x years
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Assessment of Basic Evaluation Methods

Net present value Theoretical considerations 1. Does the method consider all cash flows 2. Does the method discount cash flows at the opportunity cost of funds ? 3. Does the method satisfy the principle of value additivity ? 4. From a set of mutually exclusive projects, does the method choose the project which maximises shareholder wealth ? Practical considerations 1. Is the method simple ? 2. Can the method be used with limited information ? 3. Does the method give a relative measure ? Yes Benefit Internal cost ratio rate of return Yes Yes Payback period No Accounting rate of return ?

Yes Yes

Yes No

No No

No ?

No ?

Yes

No

No

Yes

Yes

Yes

Yes

Yes

No
No

No
Yes

No
Yes

Perhaps
No

Yes
Yes

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Evaluation Techniques in India

A survey of capital budgeting practices in India, conducted by U.Rao Cherukeri, revealed the following: Over time, discounted cash flow methods have gained in importance and internal rate of return is the most popular evaluation method. Firms typically use multiple evaluation methods. Accounting rate of return and payback period are widely employed as supplementary evaluation methods. Weighted average cost of capital is the most commonly used discount rate and the most often used discount rate is 15 percent in post-tax terms. Risk assessment and adjustment techniques have gained popularity. The most popular risk assessment technique is sensitivity analysis and the most common methods for risk adjustment are shortening of the payback period and Centre for Financial Management, Bangalore increasing

Evaluation Techniques in India

A survey of corporate finance practices in India by Manoj Anand, reported in the October-December 2002 issue of Vikalpa, revealed that the following methods (in order of decreasing importance) are followed by companies to evaluate investment proposals
Method % of companies considering as very important or important

Internal rate of return

Payback period Net present value Break-even analysis Profitability Index

85.00
67.50 66.30 58.00 35.10

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Evaluation Techniques in the US

A study conducted by William Petty and David Scott revealed the following:
Level of importance Slight Moderate Fair 15.29% 12.35 16.47 9.41 18.82 17.06% 25.29 20.59 4.71 15.29 8.82% 28.82 15.29 14.71 7.65

Technique
Accounting return on investment Payback period Net present value Internal rate of return Profitability index or benefit-cost ratio

None
12.35% 1.76 8.82 7.65 31.17

High
3.53% 30.00 33.20 59.41 11.18

No response
2.94% 1.76 5.29 4.12 15.88

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Evaluation Techniques in Japan

Japanese firms appear to rely mainly on two kinds of analysis: (a) one year return on investment analysis and (b) residual investment analysis
Residual Investment Analysis
Year 0 1 2 3 4 5 6 7 8 Cash flow (1000) 200 200 300 300 400 400 300 300 Imputed interest @ 10% Adjusted cash flow 100 90 79 57 33 100 110 221 243 367 Residual investment 900 790 569 326 -

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Summary
A wide range of criteria has been suggested to judge the worthwhileness of investment projects. They fall into two broad categories : discounting criteria and non-discounting criteria. The important discounting criteria are : net present value, benefit cost ratio, and internal rate of return. The major non-discounting criteria are : payback period and accounting rate of return. The net present value (NPV) of a project is the sum of the present values of all the cash flows - positive as well as negative - that are expected to occur over the life of the project. The decision rule associated with the NPV criterion is : Accept the project if the NPV is positive and reject the project if the NPV is negative. NPV has certain properties that make it a very attractive decision criterion : NPVs are additive; the NPV rule assumes that the intermediate cash flows of a project are reinvested at a rate of return equal to the cost of capital; NPV calculation permits time varying discount rates
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 The standard NPV method is based on the assumption that the intermediate cash flows are re-invested at a rate of return equal to the cost of capital. When this assumption is not valid, the investment rates applicable to the intermediate cash flows need to be defined for calculating the modified net present value. The benefit cost ratio is defined as the present value of benefits (cash inflows) divided by the present value of costs (cash outflows). A project is considered worthwhile if the benefit cost ratio is more than 1 and not worthwhile if the benefit cost ratio is less than 1. The internal rate of return (IRR) of a project is the discount rate which makes its NPV equal to zero. In the NPV calculation we assume that the discount rate is known and determine the NPV. In the IRR calculation, we set the NPV equal to zero and determine the discount Centre for Financial Management, Bangalore rate that satisfies this condition.

 The IRR and NPV rules lead to identical decisions provided two conditions are satisfied. First, the cash flows of the project must be conventional, implying that the first cash flow (initial investment) is negative and the subsequent cash flows are positive. Second, the project must be independent meaning that the project can be accepted or rejected without reference to any other project. There are problems in using IRR when the cash flows of the project are not conventional or when two or more projects are being compared to determine which one is the best. In the first case, it is difficult to define 'what is IRR' and in the second case IRR can be misleading. Further, IRR cannot distinguish between lending and borrowing. Finally, IRR is difficult to apply when short-term interest rates differ from long-term interest rates. There are two possible economic interpretations of internal rate of return: (i) The internal rate of return represents the rate of return on the unrecovered investment balance in the project . (ii) The internal rate of return is the rate of return earned on the initial investment made in the project.
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 Despite NPV's conceptual superiority, managers seem to prefer IRR over NPV because IRR is intuitively more appealing as it is a percentage measure. Is there a percentage measure that overcomes the shortcomings of the regular IRR? Yes, there is one and it is called the modified IRR or MIRR. It is calculated by solving the following equation : Terminal value of cash inflows Present value of cash outflows = (1 + MIRR)n The payback period is the length of time required to recover the initial cash outlay on the project. According to the payback criterion, the shorter the payback period, the more desirable the project. Firms using this criterion generally specify the maximum acceptable payback period. Payback period is widely used because 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 Centre for Financial Management, Bangalore of

 In the discounted payback period method, cash flows are first

converted into their present values (by applying suitable discounting

factors) and then added to ascertain the period of time required to recover the initial outlay of the project.

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 : it is simple to calculate; it is based on accounting information which is readily available and familiar to businessmen; it considers benefits over the

entire life of the project. However, it has serious shortcomings as well:

it is based upon accounting profit, not cash flow; it does not take into account the time value of money; it is internally inconsistent.
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 The most popular methods for evaluating small sized projects are

payback method and accounting rate of return method. For

larger projects, IRR appears to be the most commonly used method. In the U.S, internal rate of return, net present value, accounting rate of return, and Payback period are the most popular methods of project appraisal. Japanese firms appear to rely mainly on two kinds of analysis: (i) one year investment analysis and (ii) residual investment analysis

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