Chapter 8

Investment Criteria

Prof.ASHALATHA
J.K.S.H I M, NITTE
 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.

Prof.ASHALATHA
J.K.S.H I M, NITTE
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.
Prof.ASHALATHA
J.K.S.H I M, NITTE
 INVESTMENT CRITERIA

INVESTMENT
CRITERIA

DISCOUNTING NON-DISCOUNTING
CRITERIA CRITERIA

NET BENEFIT INTERNAL ACCOUNTING

PAYBACK
PRESENT COST RATE OF RATE OF
PERIOD
VALUE RATIO RETURN RETURN

Prof.ASHALATHA
J.K.S.H I M, NITTE
 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.
Prof.ASHALATHA
J.K.S.H I M, NITTE
 Benefit Cost Ratio
PVB
Benefit-cost Ratio : BCR =
I
PVB = present value of benefits
I = initial investment

Prof.ASHALATHA
J.K.S.H I M, NITTE
 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 discount • Assumes that the net
rate (cost of capital) is known present value is zero
• Calculates the net present • Figures out the discount rate
value, given the discount that makes net present
rate value zero
Prof.ASHALATHA
J.K.S.H I M, NITTE
 Calculation of IRR

Smaller NPV at the smaller rate Bigger Smaller

discount + X discount – discount
rate Sum of the absolute values of the rate rate
NPV at the smaller and the bigger
discount rates

Prof.ASHALATHA
J.K.S.H I M, NITTE
 Problems with IRR

• Non-Conventional Cash Flows

• Mutually Exclusive Projects

• Lending vs. Borrowing

• Differences between Short-term and Long-term

Interest Rates

Prof.ASHALATHA
J.K.S.H I M, NITTE
 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.

Prof.ASHALATHA
J.K.S.H I M, NITTE
 Payback Period

Payback period is the length of time required to recover the initial

outlay on the project

Pros Cons
• Simple • Fails to consider the time
value of money
• Rough and ready method • Ignores cash flows beyond
for dealing with risk the payback period
• Emphasis's earlier cash inflows
Prof.ASHALATHA
J.K.S.H I M, NITTE
 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
  Prof.ASHALATHA
J.K.S.H I M, NITTE
 Average income after tax but before interest
D :
Average investment
 
 
Average income before interest and taxes
E :
Initial investment
 
Average income before interest and taxes
F :
Average investment

Total income after tax but before depreciation

– Initial investment
G :
(Initial investment / 2) x years
Prof.ASHALATHA
J.K.S.H I M, NITTE