Chapter 6

Evaluation Criteria for Investment Decisions

6.1 Creating Value for the Investor

Value is created for an investor if the investor earns more than the investment costs.
More specifically, value is created for an investor if the investor earns more than he
or she could on other investments that he or she could make. This is because there is
an opportunity cost to investing in the project. The opportunity cost is the “cost” that
is incurred if the investor places cash into a project, so that the cash is not available
for investment in other, possibly more lucrative, investments that have the same
amount of risk attached to them. Thus, in determining the criteria for the evaluation
of the investment, the analytical techniques chosen must select for investments that
not only create value, but also create it at a greater rate than the other investments
with similar risk.
A large number of criteria have been developed that aim to determine and quan-
tify if value is created for the investor. Of these criteria, the discussion in this chapter
will be restricted to the most common criteria, that is, the payback period, return on
investment, equivalent annual charge, net present value, profitability index, internal
rate of return, the benefit-cost ratio and the modified internal rate of return. The first
two methods do not account for the time value of money, which was discussed in
the previous chapter, whereas the last six do. Those criteria that include the time
value of money are called discounted cash flow techniques. Each of these criteria
has value in decision-making. They assist in summarising the value of the invest-
ment, and often companies do not chose to invest on the basis of one criterion, but
will evaluate the project using two or more criteria.
In this chapter, these criteria will be presented, the advantages and disadvantages
discussed, and their application under differing conditions will be reviewed. Thus,
the criteria for decision-making on the economic attractiveness of a project are es-
tablished in this chapter. The application of the criteria to a variety of applications
is discussed in the next chapter.

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6.2 Non-discounted Cash Flow Techniques

6.2.1 Payback Period

The payback period determines the point in the project at which the investor gets
her investment back. In other words, the payback period is the period at which the
cash flow generated by the investment is equal to the cash invested in the project.
All positive cash flows after that are excess earnings for the investor. The payback
period is the oldest of the decision-making criteria. It is the easiest to compute, and
has intuitive value: the longer the investor has to wait for the project to return the
initial investment, the less lucrative the project.
The calculation of the payback period is illustrated in the following example.
Example 6.1: Payback period.
Suppose an investment had the cash flow profile shown in Table 6.1. Determine the payback
period. (The negative sign on a cash flow means that it is an out-flow, whereas positive
values are in-flows. This means that the investor has invested $15,000 and receives the
amounts following this $15,000 in Table 6.1.)
Solution:
The payback period is determined by calculating the time it would take until the sum of the
returns from the investment is equal to the cost of the investment. This can be determined
from the cumulative cash flow. The payback period is reached when the cumulative cash
flow changes sign from negative to positive. The cumulative cash flow, also called net cash
flow, is shown in Table 6.2 below.
The cumulative cash flow changes sign from negative to positive during the third year. This
means that the payback period is between the end of the second year and the end of the third

Table 6.1 Cash flow profile for an investment

Year Cash flow

0 −15,000
1 7,000
2 6,000
3 3,000
4 2,000
5 1,000

Table 6.2 Cumulative cash flow for the investment

Year Cash flow Cumulative cash flow

0 −15,000 −15,000
1 7,000 −8,000
2 6,000 −2,000
3 3,000 1,000
4 2,000 3,000
5 1,000 4,000