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Original Title: Investment Criteria

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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

Present Value of Inflows Present value of Outflows

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;

rate;

This Method helps to calculate the NPVs of two

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

=0

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

Cash Flow Project Co C1 IRR NPV (r12%)

P

Q

-10000

-50,000

20000

75,000

100%

50%

7857

16,964

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

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

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

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

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

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 -

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

(I0 + In)/2

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