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INVESTMENT CRITERIA

Investment Criteria
1. Discounting Criteria
NPV Benefit to Cost Ratio Internal Rate of Return

2. Non-Discounting Criteria
Payback Period Accounting Rate of Return

1.a. NPV
Ct NPV Initial Investment t t 1 (1 r )
Year 0 1 Cash Flows (1,000,000) 200,000

2
3 4 5

200,000
300,000 300,000 350,000

NET PRESENT VALUE (NPV)


Present Value of Inflows Present value of Outflows

Evaluating the Project


Accept if NPV >0 Reject if NPV <0 May Accept if NPV = 0 IF two or mutually exclusive projects, then the project with the highest NPV is chosen.

Merits of NPV
Recognizes TV of money;

Any change in cost of capital can be built into

the evaluation process by changing the discount

rate;
This Method helps to calculate the NPVs of two

mutually exclusive projects. NPV of two projects


is simply the sum of NPV of individual project

INTERNAL RATE OF RETURN (IRR) Is the rate of return that equates the NPV of a project to zero
Present Value of Inflows

Present value of Outflows

=0

Evaluating the Project

If K is the cost of capital and r is the IRR, then


Accept the project if r>K Reject the project if r < K May accept if K= r

Example- mutually exclusive projects


Cash Flow Project Co C1 IRR NPV (r12%)

P
Q

-10000
-50,000

20000
75,000

100%
50%

7857
16,964

A project costs Rs. 81,000 and is expected


to generate net cash inflows of Rs.40,000,

Rs.35,000, Rs30,000 over its life of three


years. Compute the IRR of the project.

Should the project be accepted if the Ans: 14.98% required rate is 16%? Formula:
IRR Lower rate NPV at lower rate ( Higher rate Lower rate) NPV at lower rate NPV at higher rate

Benefit Cost Ratio (BCR)


Also called Profitability Index BCR = PV of future cash flows Initial Investment

Evaluating the Project


Accept if BCR >1 Reject if BCR <1 May Accept if BCR = 1

A project costs Rs. 81,000 and is expected to generate net cash inflows of Rs.40,000, Rs.35,000, Rs30,000 over its life of three years. Compute the BCR or PI of the project if the discounting rate is 14%. 1.02 Should the project be Ans: accepted ?

Payback period
Time period required to recover the initial

outlay Example: A project involves a cash outlay of Rs

600,000 and generates cash inflows of Rs


100,000, Rs 150,000 and Rs 200,000 at

the end of 1st, 2nd and 3rd years

Limitations
Fails to consider the time value of

money It ignores cash flows beyond the payback period Its a measure of project recovery not Year the profitability 1 0 2 3 4 5 6 Cash flow of A -100000 50000 30000 20000 10000 10000 Cash flow of B -100000 20000 20000 40000 50000 30000 -

Discounted Pay Back Period


Pay back period is defined as the number of years required to recover the original investment in a project

A project involves an initial outlay of 40,000. The cash inflow in the first second and third year from the project are 10,000, 20,000 and 20,000 respectively. Compute the pay back period. If the discount rate is 10%, compute the discounted pay back period. Ans:
2 and 6 months 2 years, 11months, 14 days

ARR (Accounting Rate Of Return)

ARR = Average Income/ Average Investment

ARR = EBIT (1-t) /n

(I0 + In)/2