PROJECT

MANAGEMENT:
INVESTMENT
CRITERIA
Contents:
Introduction
Investment Criteria
Net Present Value (NPV)
Benefit Cost Ratio (BCR)
Internal Rate of Return (IRR)
Payback Period
Accounting Rate of Return
Urgency




INTRODUCTION
How to judge whether a project is good or
bad?
Following are the key steps in determining
whether a project is worthwhile or not:

Estimate the costs and benefits of the project
Assess the riskiness of the project
Calculate the cost of the capital
Compute the criteria of merit, and

Then judge whether the project is good or bad.

INTRODUCTION (contd)
How criteria of merit help in the process?

The criteria of merit will facilitate an easier
understanding of

Costs and benefits
Risk analysis, and
Cost of capital

Investment Criteria
Investment criteria are used to judge the
worthwhileness of capital projects.

These are classified as follows:
Discounting criteria
Net Present Value (NPV)
Benefit Cost Ratio (BCR)
Internal Rate of Return (IRR)
Non-discounting criteria
Payback period
Accounting rate of return
Urgency



Net Present Value (NPV)
The net present value (NPV) of a project is
the sum of the present values of all the cash
flows positive as well as negative that are
expected to occur over the life of the project.
The NPV represents the net benefit over and
above the compensation for time and risk.
The decision rule associated with NPV is
Accept the project if NPV is +ve
Reject the project if NPV is -ve
Net Present Value (NPV) (contd)
The general formula for NPV is:



Where C
t
= cash flow at the end of year t

n = life of the project

r = discount rate


1
NPV=
(1 )
n
t
t
t
C
r
=
+

NPV An example
Let us consider a project with following cash flow
stream:






If the cost of capital , r, for the firm is 10% calculate
the NPV of the proposal.






Year Cash Flow
0 Rs (10,00,000)
1 2,00,000
2 2,00,000
3 3,00,000
4 3,00,000
5 3,50,000
Solution to the example
The solution is as follows:






Since NPV is negative the project proposal
should be rejected.
1
1 2 3 4 5
We have NPV Initial investment
(1 )
Substituting the values from the table, we get
200000 200000 300000 300000 350000
NPV 1000000
(1.10) (1.10) (1.10) (1.10) (1.10)
5, 273
n
t
t
t
C
r
Rs
=
=
+
| |
= + + + +
|
\ .
=

Benefit Cost Ratio (BCR)

Benefit Cost Ratio (BCR) = PVB / I
Net BCR (NBCR) = (PVB I) / I = BCR 1
where PVB = present value of benefits
I = Initial investment (cost)
Decision Rules associated with BCR & NBCR:
When BCR or NBCR
Rule is
>1 >0 Accept
=1 =0
Indifferent
<1 <0 Reject
An example
Let us consider a project with a cost of capital as
12% and investment (cost) and benefits as
follows:







Determine BCR / NBCR to decide whether to
accept or reject the project.
Initial investment Rs 1,00,000
Benefits
Year 1 25,000
Year 2 40,000
Year 3 40,000
Year 4 50,000
Solution to the example
( )
( ) ( ) ( )
2 3 4
25000 40000 40000 50000
1.12
1.12 1.12 1.12
1.145
100000
1
1.145 1
0.145
Since BCR is greater than 1
& NBCR is greater than 0, the project may be accepted.
BCR
NBCR BCR
+ + +
= =
=
=
=
Internal Rate of Return (IRR)
The internal rate of return of a project is the
discount rate which makes its NPV equal to zero.
(OR)
It is the discount rate which equates the present
value of future cash flows with the initial
investment.
It is the value of r in the following equation:



Where Ct = cash flow at the end of year t
r = internal rate of return (IRR)
n = life of the project
( )
1
Investment
1
n
t
t
t
C
r =
=
+

NPV vs. IRR

In the NPV calculation we assume that the
discount rate (cost of capital) is known and
determine the NPV.
Whereas, in the IRR calculation, we set the
NPV equal to zero and determine the discount
rate that satisfies this condition.
An example on IRR: Determine IRR (r)
Year 0 1 2 3 4
Cash
flow
(1,00,000
)
30,000 30,000 40,000 45,000
Solution to the example on IRR
( )
( ) ( ) ( ) ( )
1
1 2 3 4
The IRR is the value of r which sati1sfies the following equation:
Investment
1
30, 000 30, 000 40, 000 45, 000
1, 00, 000
1 1 1 1
The calculation of 'r' involves a process of trial and error
n
t
t
t
C
r
r r r r
=
=
+
= + + +
+ + + +

.
Different values of 'r' must be tried till LHS is equal to RHS.
When r = 15%, then RHS = 1,00,802.
It means a little bit more than LHS.
When r = 16%, RHS = 98,641.
It means RHS is less than LHS.
Therefore, 'r' lies somewhere between 15% to 16%.
For most of the purposes this indication suffices.
Problems with IRR
IRR is unsuitable when the cash flows of the
project are not conventional or when two or
more projects are being compared to
determine which one is best.
IRR is difficult to apply when short-term
interest rates differ from long-term interest
rates, and the cost of capital itself changes
over the life of the project.
Payback Period
The payback period is the length of time
required to recover the initial cash outlay on
the project.
According to the payback criterion, the shorter
the payback period, the more desirable the
project.
For example, if two projects A & B have a cash
outlay of Rs 5,00,000, and project A has a
cash inflow of 1,00,000 per year and project B
has 1,25,000 per year. Then projects A & B
have a payback period of 5 & 4 years
respectively. Then project B is preferable over
project A.
Advantages of Payback Period
A widely used investment criterion, the
payback period has the following advantages:
It is simple, both in concept and application.
It is a rough and ready method for dealing with
risk.
Since it emphasizes earlier cash inflows, it may
be a sensible criterion when the firm is pressed
with problems of liquidity.
Limitations of Payback Period
The limitations of payback criterion, however,
are very serious:
It fails to consider the time value of money.
It ignores the cash flows beyond the payback
period.
It is a measure of the projects capital recovery,
not profitability.
Though it measures a projects liquidity, it does
not indicate the liquidity position of the firm as a
whole, which is more important.
Accounting Rate of Return
It is also called the average rate of return on
the investment.
It is a measure of profitability which relates
income to investment.
Since income and investment can be
measured in various ways, there can be a very
large number of measures for accounting rate
of return.
The higher the ARR the better the project.
Projects which have ARR>= than a
prespecified cut off rate of return(15-30%) are
accepted, others rejected
Measures of Accounting Rate of
Return

Average income after tax
A:
Initial investment
Average income after tax
B:
Average investment
Average income after tax but before interest
C:
Initial investment
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 inves
G:
( )
tment
Initial investment / 2 years
An example
Let us consider a hypothetical project and
compute the various measures of accounting
rate of return:






*IBIT Income before Interest and Taxes
**IBT Income Before Tax
***IAT Income After Tax


Year Investment
(book
value)
Depreciation IBIT* Interest IBT** Tax IAT***
1 1.00 0.30 0.30 0.10 0.20 0.100 0.100
2 0.80 0.30 0.34 0.10 0.25 0.125 0.125
3 0.60 0.30 0.40 0.10 0.30 0.150 0.150
Total
2.40 0.90 1.04 0.30 0.75 0.375 0.375
Avg
0.80 0.20 0.347 0.10 0.25 0.125 0.125
Solution to the example
Average income after tax 0.125
A: 12.5%
Initial investment 1.00
Average income after tax 0.125
B: 15.63%
Average investment 0.80
Average income after tax but before interest 0.125 0.10
C:
Initial investment 1.0
= =
= =
+
= = 22.5%
Average income after tax but before interest 0.125 0.10
D: 28.13%
Average investment 0.80
Average income before interest and taxes 0.347
E: 34.7%
Initial investment 1.0
Average income before interest a
F:
+
= =
= =
( )
nd taxes 0.347
43.38%
Average investment 0.80
Total income after tax but before depreciation - Initial investment 0.375 0.9 1.0
G: 18.33%
1
Initial investment / 2 years
3
2
= =
+
= =

Urgency
According to this criterion, projects that are
deemed to be more urgent get priority over
projects that are regarded as less urgent.
But, how can the degree of urgency be
determined?
In many situations, it is difficult to determine
the relative degree of urgency because of lack
of an objective basis.
In view of such limitations, this criterion should
not be used for investment decision making.



Questions / Discussions