M.Sc. Finance 
M.Sc. Investment & Finance 
M.Sc. International Banking & Finance 
and 
M.Sc. International Accounting & Finance 
 
2011/2012 
 
40901 – Finance I 
 
INVESTMENT CRITERIA 
 
 
J R Davies 
 
 
 
 
120
In this chapter we will evaluate the criteria that are most frequently
recommended in the financial literature for the evaluation of
investments, the net present value (NPV) and the internal rate of
return (IRR) rules. We will examine the consistency of these
investment criteria with the objective of serving the interests of the
shareholders. We will consider some of the problems posed by the use
of the internal rate of return as an investment criterion and discuss
some of the ways in which the rate of return can be modified to
overcome these problems.
We will also consider two criteria that are widely used in practice
despite some obvious theoretical shortcomings, the payback period
and the accounting rate of return. In addition, we will discuss the
problems of capital rationing – determining the optimal choice of
investments when there are insufficient funds available to fund all
profitable projects.

Objectives
By the end of the chapter you should be able to:
ƒ appreciate the advantages of using the net present value to
evaluate investment proposals
ƒ identify the strengths and weaknesses of the internal rate of
return as an investment criteria
ƒ recognise the problems posed for the internal rate of return by
mutually exclusive investments and investments characterised by
more than one breakeven rate of return
ƒ use the payback period to assess investments whilst appreciating
its limitations as an investment criterion
ƒ use the accounting rate of return to evaluate investments and
identify its shortcomings
ƒ appreciate the nature of the capital rationing problem and some
of the techniques employed to deal with the problem.
1 Investment criteria: discounted cash flow rules
Net present value rule
As we have seen, the net present value approach to the appraisal of
an investment requires the conversion of all future expected cash
flows into their equivalent values today so as to allow for the time cost
of money. The discounted cash flows are then summed to see whether
or not the investment can be expected to produce a net benefit or loss,
referred to as the net present value. A positive net present value
indicates that the capital committed to an investment can be
recovered, the interest costs covered and a surplus generated. The
surplus or net present value is an estimate of the increment in wealth
that an investment is expected to produce.

The discount rate used to determine the present value of the

investment cash flows is the lowest rate of return that the company’s
shareholders are likely to find acceptable on investments of this
nature. It should reflect the expected rate of return available to the
shareholders on other similar risk investments in the capital market.
It reflects the opportunity cost of capital and is often referred to as
the company’s cost of capital.

The formal statement of the net present value of rule is simply:

NPV ≥ 0 accept

NPV < 0 reject

where:
1 1
NPV = − C0 + C1 + L + Cn
(1 + r ) (1 + r )n
or:
n 1
NPV = − C0 + Σ Ct
t =1 (1+ r )t
Internal rate of return
The internal rate of return is the discount rate at which the NPV of
an investment proposal is equal to zero. Alternatively, it can be
described as the discount rate at which the present value of an
investment’s benefits is equal to the present value of its outlay. It is
given by the value of i, the unknown in the following equation:
1 1 1
NPV = 0 = − C0 + C1 + C2 + L + Cn
(1+ i ) (1+ i )2
(1+ i )n
n 1
0 = − C0 + Σ Ct
t =1 (1+ i )t
or
n 1
C0 = Σ Ct
t =1 (1+ i )t
The IRR is simply the breakeven rate of discount, and it can be
interpreted as the highest rate of interest that a company can pay on
a loan used to finance the investment and still expect to break even.
This approach assumes that the loan is to be paid off as the
investment produces positive net cash flows, with the interest being
charged on the outstanding balance of the loan. The balance of the
loan at any point in time can be considered to be equivalent to the
capital tied up in the investment. This leads to a view of the internal
rate of return as a measure of the productivity of the capital used in
the investment.

The formal statement of the application of the internal rate of return

rule in the assessment of an investment proposal is simply:

i≥r accept

i<r reject
If the rate of interest that a company can afford to pay on a loan used
to finance the investment is greater than the rate it has to pay, the
investment can be expected to produce a surplus and should be
accepted.

The discounted cash flow investment criteria

The internal rate of return rule and the net present value rule will
produce the same accept-and-reject decision for all investments where
an outlay is followed by cash inflows. For such investments the NPV
is a continuously declining function of the discount rate. This is
sufficient to ensure that if the NPV is positive (negative) the internal
rate of return will exceed (fall short of) the discount rate.
We can expect the NPV to decline as the discount rate increases
because of the pattern of cash flows, the negative cash flows precede
the positive cash flows, and the way in which increasing the discount
rate affects the present value of net cash flows in different time
periods. The more distant into the future that a cash flow occurs, the
greater the impact on its present value of an increase in the discount
rate. The timing of cash flows and changes in the discount rate
(shown below) evaluates the impact of increasing the discount rate
from ten to twenty per cent on the present values of two cash flows of
£100 to be received at the end of Years 1 and 10 respectively. The fall
in the present value of the Year 1 cash flow is 8.3 per cent, whereas
the present value of the Year 10 cash flow falls by 58 per cent. The
further into the future a cash flow lies, the greater the proportionate
fall in its present value as the discount rate increases.

Example
Present values of Year 1 cash flow
1
100 =100 × 0.9091= 909.1
(1+ 0.10)
1
100 =100 × 0.8333 = 833.3
(1+ 0.20)
Percentage change
(909.1 – 833.3)/909.1 x 100 = 8.3 per cent

Present value of Year 10 cash flows

1
100 =100× 0.3855 = 385.5
(1+ 0.10)10
1
100 =100× 0.1615 =161.5
(1+ 0.20)10
Percentage change
(385.5 – 161.5)/385.5 x 100 = 58.1 per cent

For investments where the

negative cash flows precede the
positive cash flows, as is usually
the case, any increase in the
discount rate pushes down the
present value of the benefits
more than it does the present
value of costs, and the NPV
inevitably falls. The general
form of the relationship is
illustrated in this figure. The
net present value must
therefore be positive at all discount rates below the internal rate of
return, the rate which the NPV is zero, and negative at all discount
rates above the internal rate of return.

Mutually exclusive investments

Many investment decisions involve a choice between competing
possibilities. This implies that it is necessary to rank investments as
well as determining their profitability. Choices have to be made, for
example, when the funding available for investments is limited and
not all profitable projects can be undertaken. This is referred to as the
capital rationing problem, and it will be considered in detail later.
In this section we will focus on the need to choose between
investments for reasons other than a financial constraint. We will
continue to assume that the investments are risk-free so as to remove
all the problems of differences in risk and uncertainty. When
undertaking one investment necessarily implies the rejection of
another, the investments are said to be mutually exclusive.
Choice may be necessary as a result of non-financial constraints on
the availability of resources required to implement different
investments. There may be a limit to the number of new investments
that the management of a company can deal with, as it may not be
feasible to recruit any additional managers in the short term.
Technological flexibility in the specification of project design may also
require the exercise of choice – for example, there may be a number of
different ways of manufacturing a given product. Here are some
examples of investments where it is necessary to exercise choice:
ƒ a firm may own some land that could be used either as a car park
or as the location of an office block
ƒ a firm may not have the managerial capacity to develop the North
American and the European markets simultaneously
ƒ a capital-intensive and a labour-intensive method of production
may be available for the manufacture of a new product, and
ƒ firms may have the option of leasing or purchasing capital
equipment.
It might be assumed that investments could be ranked either on the
basis of their net present values or their internal rates of return and
the highest-ranking investment chosen. It is possible, however, that
these investment criteria will produce different rankings and thereby
suggest the choice of different investments. If the objective of
undertaking investments is to maximise the wealth of shareholders,
the ranking by net present value should be relied upon rather than
that by the internal rate of return.
While we will now focus on the possible
differences in the rankings of investments
suggested by the alternative decision rules,
it should be emphasised that in most cases
no difference in ranking occurs. When
considering mutually exclusive investments
of similar scale and duration (similar lives),
the ranking of projects by the NPV and IRR
rules will tend to be the same. This is
illustrated in this figure. Investment B is
preferred to investment A using both the
NPV and IRR criteria. Indeed, investment B
is preferred to Investment A at any discount
rate.

To understand why the NPV and IRR rules can produce different
rankings of investments, let us consider the relationship between
these criteria a little further. We have interpreted the internal rate of
return as a measure of the productivity of capital tied up in an
investment and the NPV as the surplus or deficit that an investment
is expected to produce. The net present value depends both on the
productivity of capital in relation to the required rate of return and
the amount of capital tied up in the investment (see figure below). It
is the productivity of capital in relation to the cost of capital that
determines the sign of the net present value: for the NPV to be
positive, the internal rate of return must exceed the discount rate.
But the size of the NPV depends on the amount of capital being
employed as well as its productivity. The amount of capital committed
to an investment depends on the outlay, the life of the investment and
the pattern of the cash flows that it produces. If two investments
employ similar amounts of capital, the ranking of their NPVs will be
determined by the productivity of the capital and will therefore
correspond to the ranking by the internal rate of return. If the
amount of capital employed differs between investments, then the
ranking by the internal rate of return may not necessarily be the
same as that by the NPV. A lower IRR project may produce a higher
NPV as a result of employing more capital, either in the
form of a larger outlay or through a longer life.

Example: mutually exclusive investment

The following example illustrates a conflict between the
ranking by the NPV and IRR rules as a result of the
difference in the capital outlays required by two
projects. Investment A requires an outlay of £1,000 and
is expected to produce a net cash flow at the end of Year
1 of £1,200, producing a rate of return of 20 per cent. Investment B,
meanwhile, requires an outlay of £500 and is expected to produce a
net cash flow at the end of Year 1 of £625, producing a return of 25
per cent. On the basis of their internal rates of return, B would be
preferred to A. If the discount rate or cost of capital is 10 per cent,
however, investment A produces a higher NPV than B: £90.90 as
opposed to £68.30.

Project Outlay Net cash flow at the IRR NPV (10%)

end of the year
A (1,000) 1,200 20% £90.90
B (500) 625 25% £68.30
Difference between A and B (500) 575 15% £22.60

The commitment of an additional £500 in project A is more than

enough to offset the higher rate of return earned on the capital tied
up in project B. As investment A is twice the size of investment B, we
can notionally split it into two projects, each requiring on outlay of
£500. One of these projects can be assumed to produce a net cash flow
of £625 and is therefore equivalent to project B. The other project,
which may be interpreted as the additional investment in A in
relation to B, may be interpreted as producing the residual cash flow
of £575 that produces an acceptable rate of return of 15%.
By dividing project A into two sub-investments, one equivalent to B
and the other an incremental
investment, we can conclude
that A can do everything that B
does as well as providing an
opportunity for an additional
investment of capital that is
profitable.
Whenever the net present value
and the internal rate of return
produce a different ranking of
projects, the graphs of their net
present values as a function of
the discount rate must intersect.
This is illustrated here.

The conflict between the investment criteria only arises if the

required rate of return is less than r0 .

When r is less than r0 , the NPV for A is higher than that of B,

NPV(A) > NPV(B), whereas an intersection or crossover implies that
IRR(B) > IRR(A) > r.
 4.1

(a) If you can borrow at 10 per cent, would you prefer to invest
£1,000 in a project promising a payoff at the end of the year of
£1,500, ie a project yielding 50 per cent, or in a project of equal
risk requiring an outlay of £10 and promising a payoff of £20 in
one year’s time, ie a project yielding 100 per cent?

(b) If you can borrow on a long-term basis at 10 per cent, would

you prefer to invest £1,000 for one year to yield 50 per cent or
£1,000 for 10 years to yield 45 per cent (ie obtain a net cash flow
after ten years of £41,085)?

For projects requiring the same initial outlay of funds, any conflict in
the ranking by the internal rate of return and the net present value
rules must arise from differences in the capital tied up in the projects
after the first time period. The project with the lower rate of return
but higher NPV must have capital committed on average for a longer
period of time than the alternative project. A simple example can
again be used to illustrate the nature of the problem: two projects, A
and B, are assumed to have the same outlay but the capital invested
in project A is tied up for longer than that in B.

Cash flows
0 1 2 3 4 5 IRR NPV (10%)
Project
A (10,000) 2.500 2,500 2,500 2,500 12,500 25% 5,686
B (10,000) 4,000 14,000 40% 5,207

The opportunity to have capital employed in project A earning 25 per

cent for five years is more attractive in the sense that it produces a
higher surplus than having the same amount of capital tied up in
project B earning 40 per cent for two years.

If managers wish to use the internal rate of return for making choices
between competing investments, and many do despite its deficiencies,
there is a procedure available that ensures that the correct decision
will be reached. This procedure focuses on the rate of return on the
additional investment in the project employing the most capital, as
was suggested for the example considered earlier, and this is referred
to as the incremental yield. Differences in the amount of capital
employed in competing investments can be the result of differences in
the size of the initial outlay, the length of the investment or the
recovery rate implicit in the distribution of the investment’s net cash
flows over time.
The IRR on the differential cash flow is sometimes referred to as the
incremental yield. Subtracting the cash flows of project B from
those of A determines the additional capital committed to A in
relation to B and the added benefits that this will produce. The
difference between the cash flows of A and B constitutes the
incremental investment contained in investment A in relation to B.
The incremental investment is a notional investment. Investment A
can be thought to be equal to investment B plus the incremental
investment (∆I). If the breakeven rate of interest on the incremental
investment is greater than the discount rate, it follows that the NPV
of the incremental investment is positive at the discount rate. This
implies that the NPV of the more capital-intensive project must be
higher than that of the competing investment. This follows from the
notion that NPVs are additive:
NPV (∆I) = NPV(A) − NPV(B)
therefore
NPV(A) = NPV(B) + NPV(∆I)
and if
NPV(∆I) > 0
it follows that
NPV(A) > NPV(B)
The use of the incremental yield is illustrated in the following
example, in which project A has a higher NPV than project B but a
lower IRR:

Time period 0 1 2 3 IRR NPV (10%)

A (11,415) 5,000 5,000 5,000 15% 1,020
B (842) 400 400 400 20% 153

Differential
cash flow (A-B) (10,573) 4,600 4,600 4,600 14.6% 867
Subtracting the cash flows of project B from those of A identifies the
additional or incremental investment in A in relation to B. On this
basis, investment A’s cash flows can be divided into a set equivalent
to those of investment B plus a notional project made up of the
differential cash flows. As project B and the notional project have
rates of return exceeding the required rate of return, both are
desirable. A firm would consequently prefer to undertake both these
projects, in the form of a package deal embodied in the cash flows of
A, rather than simply project B on its own. The higher NPV of A,
despite its lower rate of return, stems from its greater capital
intensity than that of B. By focusing on the rate of return of the
incremental cash flows, it is possible to assess whether or not the
added capital is being employed to good effect.
To obtain the same ranking of projects as that provided by the NPV
rule, the following steps must be undertaken after the rates of return
on the proposed investments have been calculated:
ƒ if the largest investment has the highest rate of return, this
investment can be accepted without any further analysis (as it
employs more capital and has a higher rate of return, it must
produce a higher NPV)
ƒ if the smaller investment has the highest IRR, subtract its cash
flows from those of the larger investment
ƒ calculate the IRR of the differential cash flows
ƒ if the IRR of the differential cash flows is greater than the
required rate of return, accept the larger project despite its lower
IRR.
It is frequently asserted in textbook discussions that the problem in
using the internal rate of return to evaluate mutually exclusive
investments, each requiring the same initial outlay, stems from an
implicit assumption regarding the reinvestment of the investments’
cash flows. It is contended that the use of the internal rate of return
implicitly assumes that the cash flows produced by an investment in
the periods prior to the investment’s terminal date are reinvested at
its internal rate of return. This will not change the investment’s
expected rate of return, but it would change its net present value.

Many textbooks then deal what appears to be a fatal blow to the IRR
as an investment criterion: it is recognised that this reinvestment
assumption is invalid! It is not realistic to assume that a company is
in a position to reinvest cash flows as they are received at the same
rate of return as that offered by the initial investment. It is most
unlikely that the firm would have such projects available. And even if
it did, such projects could be financed from the firm’s other sources of
funding.

The condemnation of the internal rate of return on the basis of an

implicit mathematical reinvestment rate is not very illuminating.
The notion that the rate of return measures the productivity of the
capital tied up in a project, and that it is also necessary to take the
amount of capital being employed into account before it is possible to
determine the wealth created, appears to offer a more constructive
interpretation. Of course, this does not imply that simple IRRs
produce the correct ranking of investment possibilities.
2 Multiple rates of return
The investments considered so far have
generally consisted of an initial outlay
followed by a series of positive cash flows.
Such investments are characterised by a
unique rate of return, and we have referred
to them as simple investments. But not
all investments are of this character. For
some investments with more complex
patterns of cash flow, the net present value
can be found to be equal to zero at more
than one rate of discount. Diagrammatically this is represented by the
net present value function cutting the horizontal axis at more than
one point (this figure provides an example of investment with two or
dual rates of return, and we will consider the investment depicted in
the figure in more detail below).
Clearly, this possibility poses problems for the use of the internal rate
of return. Which of the rates of return should be compared with the
required rate of return? The answer turns out to be neither of them! If
there is more than one breakeven rate of return, it is not possible to
interpret any of them as an economically meaningful measure of
performance.
Before considering investments characterised by multiple rates of
return, it will be helpful to recall why simple investments have a
unique rate of return. As we have already seen, an increase in the
discount rate and the associated fall in the value of the discount factor
have a greater effect the more distant the cash flow being considered.
Consequently, if the negative cash flows precede the positive cash
flows, as is the case for simple investments, the overall effect of an
increase in the discount rate must be a fall in net present value. This
implies that the net present value of a simple investment is a
declining function of the discount rate. In diagrammatic terms, the
NPV falls continuously as the discount rate increases (see the figure
on page 123). As a result, there can be at most only one discount rate
at which the net present value is equal to zero.
The possibility of negative cash flows occurring subsequent to positive
cash flows implies that the net present value is not necessarily a
declining function of the discount rate.
Investments with more than one breakeven rate of discount are not
simply investments but may be considered to be a mixture of an
investment and a notional loan. At some stage in the life of the
project, more cash will have been recovered than was initially
invested, and this will be absorbed by some later cash outflows. Prior
to the outflow of the cash, the company may be considered to have
taken out more cash from the investment than it is entitled to, and
this will have to be repaid with interest in subsequent time periods.
Breakeven rates of return

The maximum number of rates of return for any

investment depends on the number of times that the
sign of an investment’s cash flows changes from one
period to the next. A simple investment, characterised
by an outlay followed by cash inflows, has one rate of
return at most:
An investment of –1,200, 500, 500, 500 has one rate
of return (12%), whereas the investment of –1,200,
300, 300, 300 has no positive rate of return. (It has a negative rate of
return of a little more than 13 per cent: it would require a subsidy to
make it attractive.)

An investment with the following cash flows –1,600, +10,000, –

10,000 has two breakeven rates of return of 25 and 400 per cent (see
figure above), whereas an investment of –2,600, 10,000, –12,000
has no positive rate of return.

Consider an open-cast coal mine requiring expenditure at the end of

its life for the restoration of land to its former use. Let us assume that
a breakeven rate of discount has been identified. If the cash flows are
evaluated assuming the project is to be financed by an overdraft, at
an interest rate equal to the discount rate, it is found that the
overdraft is cleared, and a surplus generated, prior to the final
negative cash flow. At this stage there is no longer any capital tied up
in the project at all, and it may be considered to have generated funds
that are temporarily available for the company to use in its other
activities. The surplus funds will cover the cash outflow in the
subsequent period. This perspective on non-simple investments can
be used to throw some further light on the shape of the NPV profile.
If a project is part investment and part loan, there are conflicting
forces at work when changes in the discount rate are considered. An
increase in the discount rate will lower the NPV of an investment but
increase the NPV of a loan. The figures overleaf provide examples of
NPV profiles for a simple investment and a simple loan to illustrate
the different relationships between the NPVs and changes in discount
rate. For a loan, an increase in the discount rate is associated with an
increase in the NPV, whereas we expect the NPV of an investment to
fall as the discount rate is increased.

The analysis can also be used to

indicate why the breakeven rate
of discount cannot be interpreted
in any simple economic sense.
The breakeven rate of discount
implies that the same rate will
be employed to evaluate both the
investment and loan components
of the project. We have
interpreted the rate of return as
the highest rate of interest we
could afford to pay on an
overdraft used to finance a
project and still break even.

If an investment corresponds to borrowing, a loan from a project

corresponds to a bank account being in surplus. It cannot be assumed
that the highest rate of interest that it would be possible to pay
on an overdraft and still break even could also be earned on such
surplus funds. To calculate a meaningful rate of return, it is
necessary to assume that the surplus funds available to the company
can earn a rate of return equivalent to the prevailing interest rate or
the company’s cost of capital. This implies that the rate of return is no
longer independent of the company’s cost of capital and it can no
longer be described as an internal rate of return. We will refer to this
rate as the modified rate of return, although it is also referred to
as the extended yield.

4.2 BJR’s lease on a mining concession has five years to run. A

proposal to increase annual production from a mine over the next
two years at the expense of production in the subsequent three
years needs to be evaluated. The loss of output anticipated in
Years 3 to 5 will be greater than the increase in Years 1 and 2. The
acceleration of output will be achieved by ceasing to work each
seam once productivity starts to fall significantly and once
abandoned seams cannot be reopened. The changes in the expected
cash flows are as follows:

Years 1 2 3 4 5
Cash flows +200 +200 –200 –300 –450
 Calculate the DCF rate of return on the proposal. Is this a reliable
basis for decision taking? Plot the NPV profile. Is this an
acceptable proposal if the company’s required rate of return is 20
per cent?

Unequal lives
When choosing between two or more investments it is important that
the projects are considered over an appropriate time scale. It has
already been suggested that differences in the duration of projects’
lives can lead to different rankings by IRR and NPV. It has also been
suggested that the simple IRR ranking may be misleading, and the
NPV ranking should normally be employed. But even the NPV rule
can lead to an incorrect ranking of projects if the decision is not
properly specified. It is quite possible that the correct time horizon for
the evaluation of an investment proposal is not the same as the life of
the initial investment. This problem arises if the time horizon of the
investment opportunities extends beyond the lives of the initial
investments, and it is then misleading to compare the NPVs of the
initial investments. We should instead consider the net present
values of the proposed investment programmes, taking into account
the implications of later investments as well as the initial investment.
In other words, we should evaluate the programme of investments
over the company’s planning period.

Example
This is best illustrated by means of an example. Consider two
machines, A and B, fulfilling the same technical function and to be
evaluated using a required rate of return of 10 per cent. Let A be a
more durable, efficient and expensive machine than B. The respective
cash flows are as follows:

Time 0 1 2 3 4 5 NPV (10%)

A –1,700 800 700 600 500 400 646
B –800 600 500 400 – – 459

It would appear that A is to be preferred to B on the basis of the

respective NPVs calculated at the assumed cost of capital of 10 per
cent. But these machines will have to be replaced at the end of their
working lives, and it is anticipated that they will be employed
indefinitely into the future. As a result, a series of NPVs will occur:
the NPVs for A arising every fifth year and those for B every third
year.
Time 0 1 2 3 4 5 6 7 8 9 10 →
A NPV0 NPV5 NPV10 →
B NPV0 NPV3 NPV6 NPV9 →

The easiest approach to this problem is to calculate the equivalent

annual benefit generated by each machine. The NPV of £646 for
machine A could in principle be used to purchase an annuity of £170
for the next five years:
V0 = 646 = Annuity × PVAF5 / 0.10
646 = A × 3.7908
646
A= = £170
3.7908
On the same basis, the annual benefit from machine B can be
calculated as £185. As machine B generates a higher annual benefit
than that of A it should be chosen.
As long as the decision is defined correctly, the NPV rule produces the
correct ranking of investments to maximise the wealth of
shareholders.

Discount rates and the IRR

Up until now it has been assumed that the opportunity cost of capital
is constant over time. A single discount rate has been employed: this
implicitly assumes that the discount rate for Period 1 is the same to
that for Period 2, and so on ….
r = r1 = r2 = L = rn

On this basis, the discount factor for Period 2 is written quite simply
as:
1
(1+ r1 )(1+ r2 )
If r1 is not equal to r2 , and so on, the derivation of the discount factor
requires a little more arithmetic: for example, the discount factor for
Year 2, given a rate of interest for the first and second years of 10 and
12 per cent respectively, would be:
1 1
= = 0.8117
(1+ r1 )(1+ r2 ) (1+ 0.10)(1+ 0.12)
Unless it can be assumed that the appropriate interest rate is the
same for all future time periods, the calculation of the net present
value is considerably more tedious, but it does not present any
problems for the use of the net present value investment criterion.
Unfortunately, this is not the case for the internal rate of return. If
there are a number of interest rates which one should we use as a
standard to evaluate the breakeven rate of discount? If the breakeven
rate is greater (or less) than all the various rates for different time
periods, no problem arises. But what should be done if the breakeven
rate is greater than some but less than others? The rate that should
be used to evaluate the IRR turns out to be a complex weighted
average of the different discount rates. Not only is the calculation
difficult and tedious, but the end result cannot be interpreted in any
simple economic way. Another argument for relying on the NPV rule!

NPV rule: an assessment

The primary advantage of the NPV as an investment criterion is that
it leads to a choice of investments consistent with the assumed
objective of shareholder wealth maximisation. When a firm identifies
a positive net present value investment that has not been anticipated,
the value of the firm should in principle increase by an amount equal
to the project’s expected NPV.

A proper evaluation of any proposal should allow for all costs and
benefits. The net present value rule does well on the basis of this
requirement. It takes into account all the costs and benefits over the
entire expected life of an investment and, of course, allows for the
time cost of money in assessing an investment’s net contribution.
The NPV criterion also has the advantage of obeying the ‘value
additivity principle’. This simply means that the NPVs can be
summed. When a number of projects are being undertaken, the
overall NPV can be calculated as the sum of the NPVs of the
individual projects:

NPV (investment programme) = NPV(A) + NPV(B) + ... + NPV(N)

where an investment programme is made up of N investments or

projects. The internal rate of return on projects cannot be added in
this way, though it is quite possible in principle to calculate the
internal rate of return of an entire investment programme.

The NPV rule has no apparent theoretical shortcomings, but it

appears that businessmen are reluctant to use it in practice. They do
not find it intuitively appealing. It provides a measure of the surplus
or deficit produced by a project, but this needs to be put into
perspective by relating it to the amount of capital that has to be
risked to produce the NPV. From a theoretical standpoint, the risk of
an investment can be reflected in its NPV through the use of a
discount rate that includes an appropriate risk premium. In practice,
adjustments for risk are unlikely to be entirely satisfactory, and it is
not surprising that decision takers want to know how much capital
has to be put at risk to produce a particular NPV.

One variant of the net present value rule does relate the net present
value to the initial investment. This is the profitability index,
simply defined as the ratio of the present value of an investment’s
expected positive net cash flows to its outlay:
present value of expected net cash flows
profitability index =
initial investment
n 1
Σ Ct
=
t =1 (1+ r ) t
C0

The decision rule is to accept proposals if the index is greater than

one. This produces the same accept/reject decision as the basic NPV
criterion: for the index to be greater than one, the present value of
benefits must exceed the value of the outlay, and this implies a
positive NPV.

The use of a profitability index can pose problems when projects have
to be ranked: an investment that produces a relatively high NPV in
relation to outlay does not necessarily produce a large NPV, and this
can lead to a ranking that is not consistent with maximising wealth.
Consider the following mutually exclusive projects, X and Y:

Investment PV of NPV Index

cash flows
Project X 100 200 100 2.0
Project Y 1,000 1,800 800 1.8

Project X would be ranked ahead of Y on the basis of the profitability

index but contributes less to the creation of wealth. The profitability
index clearly needs to be used with caution, but it is easy to calculate
and helps to put the contribution of a risky investment into
perspective. (We will consider the use of the profitability index further
when we discuss the capital-rationing problem.)

Assessment of the IRR

Given the weaknesses of the IRR as an investment criterion, it would
appear to be more sensible to use the net present value rate for the
evaluation of investments. But the internal rate of return continues to
be widely employed so it is necessary to develop some understanding
of its character and limitations. Interpreting the internal rate of
return as a measure of the productivity of capital tied up in a project
also offers a number of valuable insights and helps to put the net
present value of investments into perspective. If the financial
manager is sensitive to the deficiencies of the internal rate of return,
its use need not lead to a poor selection of projects. Whenever there is
a conflict between the decisions reached using the IRR and NPV
rules, it is the NPV rule that should be relied upon. Using the
incremental yield and the modified internal rate of return, however,
will allow the problems posed by mutually exclusive investments and
multiple rates of return to be overcome and produce the same ranking
the NPV rule.

Summary of the advantages of the net present value rule

It might be convenient at this stage to summarise the attributes of
NPV as an investment criterion:

ƒ it takes the time cost of money into account

ƒ it takes all the cash flows associated with a project into account
ƒ it obeys the value additivity principle – as the net present values
of projects are measured in monetary terms it is possible to add
them up to assess their combined impact
ƒ it is directly related to the overall objective of maximising the
value of the equity

ƒ it produces the correct ranking of mutually exclusive investments

ƒ it produces a simple and correct evaluation of projects having
more than one rate of return, and

ƒ it can allow for differences in discount rates over time.

3 Traditional investment criteria
Payback period
Despite the increased awareness of the advantages of using the net
present value rule as an investment criterion, many businesses
continue to use rules of thumb to evaluate investment proposals.
Among the most popular of these is the ranking of projects according
to their payback periods, that is, the amount of time necessary to
recover an investment’s initial outlay. If the project is expected to
produce constant annual cash flows, the payback period is very simple
to calculate:
initial investment outlay
payback period =
annual cash flows

If the cash flows vary from period to period then the payback period
must be calculated by summing the net cash flows from Year 1
onwards until an amount equivalent to the outlay is reached.
Different industries have different types of investments and will have
developed different ideas on what is an acceptable payback period.

The deficiencies of the use of payback as an investment criterion are

obvious. It focuses on the cash flows within the payback period and
completely ignores the cash flows expected in subsequent time
periods. Within the payback period no significance is attached to the
distribution of the net cash flows. No distinction is drawn between the
recovery of an outlay of £500 in five equal instalments of £100 at the
end of Years 1 to 5 and a single receipt of £500 at the end of the fifth
year. Indeed, payback completely fails to allow for the time cost of
money and therefore fails to take all the costs associated with an
investment into account. Failing either to take a comprehensive view
of the cash flows or to provide a satisfactory basis for dealing with the
time cost of money suggests that the payback period is unlikely to
lead to the selection of those investments expected to maximise
shareholder wealth.
The calculation of the payback is illustrated as follows:

Calculating payback
Years 0 1 2 3 4 5 Payback
(years)
Project
A –100 50 50 50 – – 2
B –100 50 50 50 50 – 2
C –160 40 80 80 40 – 2.5
D –180 60 60 60 – – 3
E –180 50 50 50 50 50 3.6

For the projects with constant cash flows, A, B, D and E, the

calculation of the payback is very simple, and even for project C,
characterised by uneven cash flows, the calculation is hardly
demanding. The ease of calculating paybacks is appealing and
probably accounts, in part at least, for its continued popularity. If the
company operated with a cut-off time period of three years, then
projects A, B, C and D would be acceptable but not E.

As payback ignores interest costs, a project may be classified as

meeting the payback criterion and being acceptable without being
able to cover all of its costs. Consider project D above: this would meet
a payback requirement of three years but will allow the recovery of
the outlay only by the end of Year 3 and makes no contribution to the
interest costs of financing the investment. This is clearly a negative
NPV project.

Despite its very obvious shortcomings, the payback period is quite

widely used. This could be a reflection of the laziness or the ignorance
of decision takers, but it could also be the result of some merits in the
use of the decision rule that are not immediately apparent. What
could these redeeming qualities be? The acceptable payback period is
often relatively short, and it has been suggested that choosing
investments with quite short paybacks helps companies without
ready access to capital to avoid liquidity problems. This might be
particularly important for smaller companies. Such companies would
reach better decisions in principle, however, if they used the NPV rule
plus a liquidity constraint, but this introduces a more complicated
decision rule that might not be appropriate for small businesses.
Another reason put forward for the use of payback is its focus on the
early cash flows expected from an investment, and these tend to be
less risky than later cash flows. Even if the risk of cash flows
increases with time (and this is not always the case), the use of the
payback period adjusts for risk in a rather crude way: risk is ignored
up to the end of the payback period, and after this point cash flows
are implicitly deemed to be so risky that they are given a value of zero
in the appraisal. The use of the net present value rule, with the
discount rate increasing over time to reflect increasing risk, provides
a more sensible approach.

Another possible reason for the continued use of payback, even

though its weaknesses are transparent, is its use as a management
control mechanism. Managers may not be too concerned with
estimates of the cash flows of projects beyond the time period for
which they are likely to be held responsible for its outcome. The more
mobile the manager, the shorter his or her time horizon is likely to be.
It seems to be believed that more realistic estimates of cash flows will
be produced by managers in these circumstances by requiring
relatively short acceptable payback periods.
One weakness of the payback period that can be quite easily overcome
is its failure to allow for the time cost of money. Instead of using cash
flows to calculate the payback period, the discounted cash flows could
be used instead. The discounted payback rule allows for the time cost
of money and the distribution of cash flows within the payback period
but continues to ignore cash flows beyond the specified cut-off point.
One of the perceived weaknesses of payback as an investment
criterion is the seemingly arbitrary way in which the maximum
acceptable payback period is determined. But it is possible that the
payback period is set in such a way so as to require a minimum rate
of return. This is quite plausible if the cash flows for certain types of
investment tend to follow a similar pattern. For example, if the
machines used by a company tend to have equal lives and the benefits
they produce are constant from year to year, it is a simple matter to
determine the payback period that is consistent with a given rate of
return.

The discounted payback period constitutes an improvement over the

simple payback period by taking the time value of money into
account. This period is determined by discounting the expected
positive net cash flows and then summing these until the sum equals
the outlay. The discounted payback period allows for the recovery of
the capital outlay and the cost of funds tied up in the project. The
sum of the discounted cash flows expected after the discounted
payback period is equal to the investment’s net present value. This is
illustrated in the following example.
 DISCOUNTED
PVF PRESENT CUMULATIVE PAYBACK CUMULATIVE PAYBACK
YEAR NCF (12%) VALUE NCF PERIOD DCF PERIOD
(4 years) (5 years)
0 -10000 1.0000 -10000.00 -10000 -10000
1 1500 0.8929 1339.29 -8500 1500 -8661 1339
2 2000 0.7972 1594.39 -6500 2000 -7066 1594
3 3000 0.7118 2135.34 -3500 3000 -4931 2135
4 3500 0.6355 2224.31 0 3500 -2707 2224
5 4770 0.5674 2706.63 SUM= 10000 2707
6 4770 0.5066 2416.63 SUM= 10000
7 4000 0.4523 1809.40
8 2000 0.4039 807.77
NPV= 5033.75
SUM= 5033

This illustration assumes an outlay of £10,000 that is expected to be followed by cash inflows
for the next eight years. The simple payback period is four years. The discounted payback
period is inevitably longer at five years, with the discounted cash flows from year six to year
eight providing the basis of the expected net present value.

Summary of the weaknesses of the payback criterion

ƒ The payback criterion is not tied in any simple or obvious way to
the assumed financial objectives of the firm

ƒ The payback criterion does not take into account all the
anticipated benefits of a project– cash flows after the acceptable
payback period are ignored

ƒ The simple payback criterion fails to take all the expected costs of
a project into account as it does not allow for the time cost of
money

ƒ The maximum acceptable payback cut-off period appears to be

chosen on an arbitrary basis, and

ƒ The use of payback is often defended as a simple way of dealing

with risk but it might encourage the adoption of high-risk projects
– short paybacks on the basis of high expected cash flows are
likely to be associated with high-risk projects that are being
avoided by other companies.
 The discounted payback period overcomes some of the problems
associated with the payback period, but again ignores the
contribution of cash flows beyond the discounted payback period.

4.3 Determine the payback period required to produce a 20 per

cent DCF rate of return on investments that produce constant cash
flows and have expected lives of ten years. (The answer to the
question is independent of the level of the investment. You can
assume an outlay of £1000, and determine the breakeven NCF for
the 10 year period given the required rate of return of 20 per
cent.).)

Accounting rate of return

Another widely used basis for assessing investments is the accounting
rate of return on capital employed, the ratio of profits to the value of
the assets employed. This is the ratio that is normally used in the
monitoring and assessment of business performance.
Unfortunately, the ratio tends to be defined in different ways by
different users, although it is most often taken to be the average net
annual profit over the average value of the assets employed. The
annual capital employed is the average of the opening and closing
value of assets:
average annual profit
average accounting rate of return =
average value of assets

Consider the project requiring an outlay of £1,200 that is expected to

produce three annual cash flows of £500 each. If the assets are
depreciated on a straight-line basis over three years, the annual
depreciation charge is £1,200/3 = £400. Calculating the annual profit
as the net cash flow less the depreciation charge, the accounting rate
of return can be determined as follows:
 1 2 3
Net cash flow 500 500 500
Less depreciation 400 400 400
Annual profit 100 100 100
Opening value of assets 1200 800 400
Closing value of assets 800 400 0
Average value of assets 1000 600 200
Rate of return on assets employed 10% 16.67% 50%
Average rate of return = 25.56%
If the average capital outstanding had been taken over the three-year
period, with an opening value of £1,200 and a closing value of zero to
give an average of £600, the average rate of return would have been
16.67 per cent.

The accounting rate of return suffers from a number of weaknesses:

ƒ it is not tied to the cash flows of an investment and ignores the

value of the time cost of money

ƒ the profit figure depends in part on the depreciation charge, and

to some extent this will reflect the judgement of the accountant

ƒ using an average figure implies that the distribution of benefits

over the life of the investment is not taken into account – no
allowance is made for the differences in the value of immediate
and more distant benefits, and

ƒ there is no theoretical basis for determining the required

accounting rate of return to use as a yardstick.

The accounting rate of return continues to be widely employed as an

investment criterion despite the lack of any theoretical justification.
As net profit is averaged over the life of the project and is calculated
after deducting depreciation, it does not focus on cash flows or their
timing. While in a limiting case – an infinite life project with constant
cash flows – a relationship can be developed between the accounting
and the internal rates of return it is not generally very easy to infer
anything about the discounted rate of return from information
provided on the accounting rate of return.
4 Capital rationing
The analysis developed so far has assumed that the firm has access to
the funds necessary to finance all profitable investment projects, ie
those found to have positive net present values. It has also been
assumed that the cost of these funds, determined in the capital
market, provides the discount rate to be used to evaluate the expected
cash flows of projects. However, managers often find that the budget
available for the financing of investment projects is fixed and the
funds at their disposal are not sufficient to finance all the projects
that appear to be profitable. This implies that managers sometimes
have to choose between profitable projects. This is referred to as the
capital-rationing problem.
The capital-rationing problem is not easily resolved. When it is a
continuing long-term problem two primary difficulties arise. Firstly,
the opportunity cost of capital is no longer determined in the capital
market but by the return on the most profitable project that the firm
is unable to finance. To identify the marginal project, choices must be
ranked according to their net present values per unit of capital
employed. But this requires knowledge of the discount rate that the
exercise is expected to generate. This pure or hard capital-rationing
problem cannot be resolved. Secondly, the choice of projects can
exercise some influence over the capital constraint in future time
periods. This will occur if the cash flows from the projects chosen
today play a part in determining the level of future availability of
cash and capital budgets, and firms faced by a capital constraint often
depend heavily on internally generated funds.

Long-term capital rationing may well lead to projects with relatively

short payoff periods being favoured over longer-life projects. From an
analytical standpoint, it suggests that the allocation of funds today
cannot be divorced from the selection of projects in future time
periods. This poses difficulties, but these can be overcome, in principle
at least, by using a multi-period programming model. Whether
sufficient information will be available about all the potential projects
for every year for the period over which capital will have to be
rationed is an entirely different matter.

It is sometimes suggested that programming can resolve the pure

capital-rationing problem, but this is not the case. It allows the
difficulties posed by the interdependence of projects over time to be
resolved if the profitability of projects can be determined. However,
the profitability of projects can only be assessed if the discount rate is
known and the programming approach does not provide a solution to
this basic problem.

Capital rationing may arise as a result of:

ƒ capital market imperfections

ƒ self-imposed constraints.

Capital market imperfections occur as a result of information and

transaction costs, and are likely to be more important in countries in
which capital market institutions are at an early stage of
development. It is not likely that capital rationing will be a
continuing long-term problem for larger companies in the UK where
the capital market is well established.

Self-imposed constraints may occur when a businessman is reluctant

to use external funding as this is perceived to be a threat to his
control over the business. Some businessmen are prepared to trade off
the advantages of independence and control against profits. As a
result of issuing additional shares, it may not be possible to maintain
control over 50 per cent of shares, although it is not generally
necessary to hold a majority of shares to maintain control if holdings
are widely dispersed. Moreover, effective control may also be reduced
as a result of the conditions imposed by bankers making loans to a
company. The influence exercised by banks on profitable companies
may be quite limited, but firms experiencing difficulties are likely to
find bankers to be more effective in exercising control than any
minority shareholder.
Constraints on investment expenditure are sometimes imposed
within organisations. For example, the divisions of a business may be
allocated budgets for capital expenditure that are fixed in the short
run. In these circumstances divisional managers may identify a
number of profitable projects requiring capital in excess of their
budget. In the short term, they will be forced to allocate the available
funds to the most profitable projects while arguing the case for the
relaxation of the constraint in the longer term. Similarly, government
departments may be allocated budgets that do not allow them to
undertake all the projects deemed to be socially desirable. Such
constraints may persist in the longer term if the government is
reluctant to increase taxes to finance more projects. The problem of
evaluating projects when capital is rationed within organisations is
eased to the extent that, in principle, the appropriate discount is
known.

It is important that the source and nature of the capital-rationing

problems are identified. While the pure capital-rationing problem
may not be resolved, solutions can be developed for less extreme
forms of the problem.

It is often suggested that the internal rate of return provides a

suitable method of ranking projects when there is a capital constraint.
It is contended that its weaknesses for the evaluation of mutually
exclusive projects become strengths in the context of capital rationing.
These weaknesses stem from the bias it produces in favour of projects
requiring small capital outlays and having short lives. When capital
is limited in supply there are advantages in undertaking low capital-
intensive projects with quick payoffs. They use less capital and return
the capital quickly, allowing its redeployment in other projects.
However, whilst solutions to the capital-rationing problem are likely
to bias the choice of projects towards those requiring less capital, this
does not imply that the use of the internal rate of return as a basis for
ranking projects will necessarily lead to the optimal allocation of
funds.
If all projects had the same lives, in the sense of having each unit of
capital tied up for the same period of time, the ranking of projects
according to their NPVs per unit of outlay would be identical to that
produced by ranking according to their internal rates of return. Given
the period of time that a unit of capital is tied up, its NPV depends
simply on its rate of return. Focusing on NPV per unit of outlay
produces the same advantages as the internal rate of return in
economising the use of capital.

What of the second of the supposed advantages of the internal rate of

return – the bias it produces in favour of short-lived projects? If the
capital constraint is of a short-term nature, binding possibly for only
one period, the timing of the payoffs from projects is only important in
determining the project’s net present value. The pattern of the payoffs
will not influence the choice of projects in future time periods. As a
result, given two profitable projects with the same outlay and
identical rates of return, the longer-life project with the higher NPV,
as each unit of equally productive capital will be at work for longer,
should be chosen. If, on the other hand, the capital constraint is
expected to be binding for a number of periods, producing a long-term
capital-rationing problem, it is possible that the internal rate of
return ranking will prove to be superior to the ranking by NPV per
unit of outlay. Which turns out to be best depends on the nature of
the firm’s capital-rationing problem and the nature of its current and
future investment possibilities.

Conclusion
This chapter has considered the various investment criteria that are
more widely used and discussed some of the problems of determining
the optimal set of investments when capital has to be rationed. It has
been contended that the net present value rule generally provides the
basis of assessing investments. The discounted rate of return provides
an alternative investment criterion that takes the time cost of money
into account but was found to run into problems when investments
have to be ranked or are not simple investments. It was pointed out,
however, that the internal rate of return decision rule could be
modified to produce the same decisions as the NPV rule. The internal
rate of return provides insights into the nature of investments and
provides a useful supplementary measure of an investment’s worth to
be used in conjunction with the NPV rule.