Investment Criteria

Topics Covered
 A Review of the Basics
 The Payback Period

 Internal Rate of Return

 Choosing Capital Investments when

Resources are Limited
NPV and Cash Transfers
 CFO Decision Tools

Percent of CFOs who always or almost always use a given technique:

Graham J.R. and Harvey C.R., (2001), The Theory and Practice of Finance:
Evidence from the Field, Journal of Financial Economics 61, 187-243.
 Review of Basics
 Book Rate of Return
 Average income divided by average book
value over project life
 Also called accounting rate of return

 Ignores the time value of money

 Does not use market values

book income
Book rate of return 
book assets
 Payback Period
 Payback Period

 Number of years before cumulative cash flow

equals the initial investment
 Payback Rule
 Only accept projects that pay back within
desired time frame
 Ignores all cash flows after the payback

period (cutoff date)

 It does not consider the time value of money
Example:
 Internal Rate of Return (IRR)
Example:
Tool A costs $4,000. Investment will generate
$2,000 and $4,000 in cash flows for two
years. What is IRR?
2,000 4,000
NPV  4,000   0
(1  IRR ) (1  IRR )
1 2

IRR  28 .08 %
Internal Rate of Return
Internal Rate of Return
Pitfall 1: Lending or Borrowing?
NPV of project increases as discount rate
increases for some cash flows
 Internal Rate of Return
Pitfall 2: Multiple Rates of Return
Certain cash flows generate NPV = 0 at two
different discount rates
Following cash flow generates NPV = $A2.53
billion at 10% discount rate. NPV=0 at IRR of
3.5% and 19.54%
Multiple Rates of Return
Internal Rate of Return
Pitfall 2: Multiple Rates of Return
Project can have 0 IRR and positive NPV
Internal Rate of Return
Pitfall 3: Mutually Exclusive Projects
IRR sometimes ignores magnitude of project
Internal Rate of Return
Pitfall 4: More than One Opportunity
Cost of Capital
 Assumes that the discount rates are stable
during the term of the project
 Implies that the project cash flows are

reinvested at the IRR (false assumption)

 Choosing Capital Investments when
Resources are Limited
 Profitability Index (PI)
 Tool for selecting between project
combinations and alternatives
 Set of limited resources and projects can

yield various combinations

 Highest weighted average PI indicates

optimal project
Choosing Capital Investments
when Resources are Limited
Cash Flows ($millions)
Project C0 C1 C2 NPV at 10% Profitability
Index
A -10 +30 +5 21 2.1

B -5 +5 +20 16 3.2

C -5 +5 +15 12 2.4

NPV
Profitabil ity index 
investment
Example:
Select best projects for $300,000
Project NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

Choose the combination with the highest weighted

average PI.
 Example: Cont.
Project NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

Select projects with highest weighted average PI:

WAPI (BD) = 1.13x(125/300)+1.08x(150/300)=1.01

 Example: Cont.
Project NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08

Select projects with highest weighted average PI:

• WAPI (BD) = 1.01
• WAPI (A) = 0.77
• WAPI (BC) = 1.12

PI method indicates that B and C combination is better. It

also has the highest NPV.
 Choosing Capital Investments when
Resources are Limited
 Capital Rationing
 Limit set on amount of funds available for
investment
 Soft Rationing
 Imposed by management
 Hard Rationing
 Imposed by unavailability of funds in capital
market
Web Resources
www.djindexes.com
www.spglobal.com
www.wilshire.com
www.msci.com
www.mscibarra.com
 Lecture 4: Practice Homework

 BMA2017: Chapter 5
 All Examples
 Exercises: 1, 3, 8, 12, 14, 15