Name: Muhammednur Qadire Muze

Student ID: ST10166292

Course Name/Code: Financial management/ECM 105

Assignment Question: There are 5 financial criteria for accepting and rejecting projects: Net
Present Value, Regular Payback, Discounted Payback, Internal Rate of Return and Profitability
Index. Explain each in detail. Which according to you is the most suitable criteria and why?
Support your answer with examples.
 INTRODUCTION

The process a profit seeking company undertakes to evaluate potential major projects or
investments represent the so called capital budgeting. It represents the overall process of
analyzing proposed projects and deciding which one among the alternatives to include in the
capital budget. Construction or purchasing of a new plant or a big investment in an outside
venture and or within the company are typical examples of projects that would require capital
budgeting before they are approved or rejected. It is a measurable way for businesses to
determine the long-term economic and financial profitability of any investment project.

Different business organizations apply different evaluation techniques to either accept or reject
the capital budgeting projects in terms of its financial feasibility. Commonly, most profit seeking
business companies use the following financial criteria for deciding to accepts or reject proposed
projects.

 Net present value (NPV)

 Regular Payback
 Discounted Payback
 Internal Rate of Return (IRR)
 Profitability Index (PI)

Therefore, this paper intends to explain the nature, strength, weakness and interrelationship of
the above-mentioned financial criteria to evaluate particular proposed project. And also, it tries
to suggest the most suitable criteria; based on empirical evidence.

1.1. Net Present Value (NPV)

As stated in Brigham and Houston (2012), “Net present value is the present value of the project’s
free cash flows discounted at the cost of capital (p. 371).” This means that, in the NPV value
method, all cash flows are discounted to present value by using the required rate of return.
According to Keown, Martin, Petty, and Scott Jr. (2005), net present value is the present value of
free cash-flows after tax less the project’s initial cash outlay. Therefore, it is the discounted cash-
flow approach to the capital budgeting.

NPV can be expressed as follows (Keown et al, 2004):

[ CF 1
(1+k)1 ] [
+
CF 2
(1+k)2 ] [
+
CF 3
(1+k)3 ] [
+
CF 4
(1+k)4 ] + …………. +
[ CFn
(1+k)n ] - ICO

Where: CF = cash inflow per period; K = Discount rate; ICO= Initial cash outlay (initial
investment); K = Investors required rate of return
As stated in Keown et al (2005), accept-reject criterion based on NPV has been stated as follow:
NPV ≥ 0.0: Accept, and NPV < 0.0: Reject

The other thing to be considered in the decision process is to know the nature of proposed
projects. Whether the proposed projects are independent (whose acceptance doesn’t affected by
one another: any projects would be accepted, if NPV > 0) or mutually exclusive (the acceptance
of one means rejection of another: the one with highest NPV would be accepted).

Let’s take numerical example to show NPV; given the following cash flow (in Ethiopian Birr),
and investors required rate of return (K) is 10%:

Project initial cost CF1 CF2

A Br 10, 000 0 Br 14,400
B Br 10,000 Br 10,000 Br. 2400

[
CF 1
+
CF 2
NPV = (1+K )1 (1+K )2
] - ICo
[ CF 1
+
CF 2
(1+K )1 (1+K )2 ] - ICo

=
[ Br 0 Br 14,400
+
(1.1)1 (1.1)2 ] - Br 10,000
[ Br
Br 10 , 000 Br 2400
(1. 1)2
+
(1. 1)2 ] - Br 10,000

NPV: A= Br 1,901 B= Br 1,074

Decision: if projects are independent; accept both projects since their NPV is greater than zero.
If projects are mutually exclusive; accept project A since it has the highest NPV.

According to (Brigham and Houston, 2012 and Keown et al, 2005), the advantages and
disadvantages of NPV have been identified as follows:

A. Advantages of NPV
 It is sensitive to the true timing of the benefits resulting from the project.
 It deals with free cash flows rather than accounting profits.
 It is an objective method of selecting and evaluating of the project
B. Disadvantages of NPV
 It needs the detailed & long-term forecasts of free cash flows accruing from the
project's acceptance.
 The NPV does not consider the life of the project.
1.2. Regular Payback Period (PBP)

Regular payback is the number of years required for an investment’s cumulative cash flows to
equal its net investment (Higgins, 2007). Brigham and Houston (2012) further explained
payback period as: “the length of time required for an investment’s cash flows to cover its initial
investment (p. 387).”

To calculate the payback period, simply adding up projects expected positive cash flows, until
the sum equals the amount of the project’s initial investment. But, it depends on the basis of cash
flows (whether annuity form or non-annuity form).

PBP for annuity cash flow = Net initial investment

Uniform increase in annual cash flows

Unresolved Cost at full re cov ery

the start of the Year
PBP= Year before full Recov ry+
Cash flow during the year
To apply the payback decision method, firms must decide what payback time

Decision Rule:
period is acceptable for projects and the calculated payback period should be less than some pre-
specified number of periods (Higgins, 2007). For mutually exclusive projects: the shorter the
payback, the better the projects.

Let’s take an example: An investment has a net investment of Br 12,000 and annual cash flows
of Br. 4, 000 for five years. The project has a maximum desired payback period of 4 years.

Solution: The PBP = Br 12, 000 = 3 years (Since the investment has uniform cash inflows)
4,000
: Accept the project because the calculated payback period is less than the specified

Decision
payback period.

Brigham and Houston (2012) identified the advantages and disadvantages of PBP as follow:

Advantages:
 It is easy to use and understand
 It provides information about risk and liquidity

Disadvantages:
 It does not recognize the time value of money
  It ignores the impact of cash inflows received after the payback period
 There is no necessary relationship between a given payback & investors wealth
maximization.

1.3. Discounted Payback Period (DPBP)

As stated in Brigham and Houston (2012), discounted payback period is developed by analysts to
counter the first criticism (ignoring time value of money) of regular payback period. In this
method, discounted cash flows are used to find the payback period.

Apart from this (recognition of time value of money, in case of DPBP), there is no any difference
between regular payback period and discounted payback method. Therefore, it is redundant to
explain each and everything.

1.4. Internal Rate of Return (IRR)

IRR is the discount rate that enables a project’s NPV to equal zero (Brigham and Houston,
2012). It is also defined as the discount rate that produces a zero NPV. Mathematically, it’s

[ CF 1
+
CF 2
+
CF 3
+
CF 4
expressed as follow: (1+IRR )1 (1+IRR )2 (1+IRR )3 (1+IRR )4
+....+
CFn
(1+IRR )n - ICO = 0 ]
As in the case of the payback criterion, computing IRR depends on whether or not its cash flows
are in annuity form.

Higgins (2007) stated four basic steps to compute IRR, as follow:

1st. Identify the closest rates of return

2nd. Compute the NPV for each of these two closest rates.
3rd. Compute the sum of the absolute values of the NPV obtained in step 2
4th. Divide the sum obtained in Step3 in to the NPV of the smaller discount rate.
Decision rule: If the IRR of a project is greater than the firms cost of capital (required rate of
return) accept the project, if IRR is less than the cost of capital, reject the project.

Advantages of IRR:
 Recognizes the time value of money
 Recognizes income over the whole life of the project
 The percentage return allows a sound basis for ranking projects
Disadvantages of IRR:
 It often gives unrealistic rates of return
  Give different rates of return

1.5. Profitability Index (PI)

benefit/cost ratio. It is the ratio of the present value of cash flows (PVCF) to
It is also known as
the initial investment of the project on a relative basis (Higgins, 2007). It is computed as follows:

PVCF
PI =
Inifial investemtn

Decision rule:
In this method, a project with PI greater than 1 is accepted but a project is rejected when its PI is
less than 1. This method is closely related to the NPV approach (Higgins, 2007).

1.6. Suitable Criteria

Even if, all of the above-mentioned criteria provide useful information, NPV is the best method.
This is in line with Brigham and Houston (2012): “NPV is always better because it tells us how
much value each project will add to the firm, and value is what the firm should maximize (p.
376).” Moreover, NPV is the single most suitable criterion because it provides a direct measure
of value the projects adds to the shareholder wealth (Brigham and Houston, 2012).

Conclusion
To sum up, different business organizations apply different evaluation techniques to either accept
or reject the capital budgeting projects in terms of its financial feasibility. Even if different
criteria provide different types of information, the greatest weight should be given to the NPV.
REFERENCE

Brigham, E.F., & Houston, J.F. 7thed. (2012). Fundamentals of Financial Management. Mason,
OH 45040, USA: South-Western CENGAGE learning

Higgins, R.C. 8th ed. (2007). Analysis for Financial Management. New York, NY, 10020, USA:
McGraw-Hill

Keown, A.J., Martin, J.D., Petty, J.W., and Scott Jr., D.F. 10 thed. (2005). Financial Management:
Principles & Applications. Hoston, TX, USA: Prentice Hall