INVESTMENT CRITERIA

BY:CHANDNI SHARMA
DEEPJYOTI MANDAL
SANJANA JAIN
SWATI BADWANI
VINAY GOLCHHA

TWO DIMENSION OF COST ANALYSIS

PROJECT-BY-PROJECT DIMENSION: ONE PROJECT SPANS MULTIPLE

ACCOUNTING PERIODS
PERIOD-BY-PERIOD DIMENSION: ONE PERIOD CONTAINS MULTIPLE
PROJECTS

CAPITAL BUDGETING

CAPITAL BUDGETING IS MAKING A LONG-RUN PLANNING DECISIONS FOR

INVESTING IN PROJECTS
CAPITAL BUDGETING IS A DECISION-MAKING AND CONTROL TOOL THAT
SPANS MULTIPLE YEARS

CAPITAL BUDGETING METHODS

Investment
Criteria

Non
Discountin
g Criteria

Discountin
g Criteria

NPV

Benefit
Cost Ratio

IRR

PayBack
Period

Accounting
Rate of
Return

DISCOUNTED CASH FLOWS

DISCOUNTED CASH FLOW (DCF) METHODS MEASURE ALL EXPECTED
FUTURE CASH INFLOWS AND OUTFLOWS OF A PROJECT AS IF THEY
OCCURRED AT A SINGLE POINT IN TIME
THE KEY FEATURE OF DCF METHODS IS THE TIME VALUE OF MONEY
(INTEREST), MEANING THAT A DOLLAR RECEIVED TODAY IS WORTH MORE
THAN A DOLLAR RECEIVED IN THE FUTURE

DISCOUNTED CASH FLOWS

(CONTINUED)
DCF METHODS USE THE REQUIRED RATE OF RETURN (RRR),
WHICH IS THE MINIMUM ACCEPTABLE ANNUAL RATE OF
RETURN ON AN INVESTMENT.
RRR IS THE RETURN THAT AN ORGANIZATION COULD EXPECT
TO RECEIVE ELSEWHERE FOR AN INVESTMENT OF
COMPARABLE RISK
RRR IS ALSO CALLED THE DISCOUNT RATE, HURDLE RATE,
COST OF CAPITAL OR OPPORTUNITY COST OF CAPITAL

NET PRESENT VALUE (NPV) METHOD

NPV METHOD CALCULATES THE EXPECTED MONETARY GAIN OR LOSS
FROM A PROJECT BY DISCOUNTING ALL EXPECTED FUTURE CASH
INFLOWS AND OUTFLOWS TO THE PRESENT POINT IN TIME, USING THE
REQUIRED RATE OF RETURN
BASED ON FINANCIAL FACTORS ALONE, ONLY PROJECTS WITH A ZERO OR
POSITIVE NPV ARE ACCEPTABLE

THREE-STEP NPV METHOD

1. DRAW A SKETCH OF THE RELEVANT CASH INFLOWS AND
OUTFLOWS
2. CONVERT THE INFLOWS AND OUTFLOWS INTO PRESENT
VALUE FIGURES USING TABLES OR A CALCULATOR
3. SUM THE PRESENT VALUE FIGURES TO DETERMINE THE
NPV. POSITIVE OR ZERO NPV SIGNALS ACCEPTANCE,
NEGATIVE NPV SIGNALS REJECTION

THE NET PRESENT VALUE METHOD:

SUMMARY

NPV METHOD ILLUSTRATED

INTERNAL RATE OF RETURN (IRR)

METHOD
THE IRR METHOD CALCULATES THE DISCOUNT RATE AT WHICH THE
PRESENT VALUE OF EXPECTED CASH INFLOWS FROM A PROJECT EQUALS
THE PRESENT VALUE OF ITS EXPECTED CASH OUTFLOWS
A PROJECT IS ACCEPTED ONLY IF THE IRR EQUALS OR EXCEEDS THE RRR

HOW DO WE CALCULATE IRR?

NPV = NET PRESENT VALUE OF THE PROJECT

INITIAL INVESTMENT
CT=CASH FLOW AT TIME T
IRR = INTERNAL RATE OF RETURN

SIGN CHANGES IN THE CASH FLOWS

IRR EVALUATES A PROJECT CORRECTLY WHEN THERE IS AN INITIAL NEGATIVE
CASH FLOW, FOLLOWED BY A SERIES OF POSITIVE ONES (-+++).
IF THE SIGNS ARE REVERSED (+---), THAT WILL CHANGE THE ACCURATENESS
OF THE IRR CALCULATION.
IF THERE ARE MULTIPLE SIGN CHANGES IN THE CASH FLOWS (+-+-+) OR (-++-), YOUR CALCULATION WOULD RESULT IN MULTIPLE IRRS, ALSO MAKING
THE PROJECT VERY DIFFICULT TO EVALUATE.

IRR METHOD

ANALYSTS USE A CALCULATOR OR COMPUTER PROGRAM TO

PROVIDE THE IRR

TRIAL AND ERROR APPROACH:

USE A DISCOUNT RATE AND CALCULATE THE PROJECTS NPV. GOAL: FIND
THE DISCOUNT RATE FOR WHICH NPV = 0
1.

IF THE CALCULATED NPV IS GREATER THAN ZERO, USE A HIGHER DISCOUNT RATE

2.

IF THE CALCULATED NPV IS LESS THAN ZERO, USE A LOWER DISCOUNT RATE

3.

CONTINUE UNTIL NPV = 0

SO NOW WHAT?
ONCE YOUVE CALCULATED IRR
IF IRR IS GREATER THAN THE COST OF CAPITAL, THEN YOUVE GOT A GOOD
PROJECT ON YOUR HANDS (GO FOR IT!).
IF IRR IS LESS THAN THE COST OF CAPITAL, THEN YOUVE GOT A BAD
PROJECT ON YOUR HANDS (DONT UNDERTAKE THE PROJECT).
IF THE IRR AND COST OF CAPITAL ARE EQUAL, THEN YOU SHOULD USE
ANOTHER METHOD TO EVALUATE THE PROJECT!
BASICALLY, THE HIGHER THE IRR, THE BETTER THE PROJECT

IRR METHOD ILLUSTRATED

COMPARISON NPV AND IRR METHODS

IRR IS WIDELY USED

NPV CAN BE USED WITH VARYING RRR
NPV OF PROJECTS MAY BE COMBINED FOR EVALUATION PURPOSES, IRR
CANNOT
BOTH MAY BE USED WITH SENSITIVITY ANALYSIS (WHAT-IF ANALYSIS)

SENSITIVITY ANALYSIS ILLUSTRATION

WHAT IS A BENEFIT-COST RATIO?

A BENEFIT-COST RATIO (BCR) IS AN INDICATOR, USED IN THE FORMAL
DISCIPLINE OF COST-BENEFIT ANALYSIS,, THAT ATTEMPTS TO SUMMARIZE THE
OVERALL VALUE OF MONEY OF A PROJECT OR PROPOSAL.
A BCR IS THE RATIO OF THE BENEFITS OF A PROJECT OR PROPOSAL, EXPRESSED
IN MONETARY TERMS, RELATIVE TO ITS COSTS, ALSO EXPRESSED IN MONETARY
TERMS.
ALL BENEFITS AND COSTS SHOULD BE EXPRESSED IN DISCOUNTEDPRESENT
VALUES.

CONTINUE..
BENEFIT COST RATIO (BCR) TAKES INTO ACCOUNT THE AMOUNT OF
MONETARY GAIN REALIZED BY PERFORMING A PROJECT VERSUS THE
AMOUNT IT COSTS TO EXECUTE THE PROJECT. THE HIGHER THE BCR THE
BETTER THE INVESTMENT.

GENERAL RULE OF THUMB IS THAT IF THE BENEFIT IS HIGHER THAN THE

COST THE PROJECT IS A GOOD INVESTMENT.

 IN PRACTICE, THE RATIO OF NPV TO EXPENDITURE IS EXPRESSED AS A BCR.

THERE ARE TWO WAYS OF DEFINING THE RELATIONSHIP BETWEEN BENEFITS AND
COST:
BENEFIT-COST RATIO(BCR)=PVB/I
NET BENEFIT-COST RATIO(NBCR)=PVB-I/I

=BCR-1
WHEREPVB=PRESENT VALUE OF BENEFIT
I= INITIAL INVESTMENT

COST-BENEFIT ANALYSIS
COST-BENEFIT ANALYSIS IS A TERM THAT REFERS
BOTH TO:
HELPING TO APPRAISE, OR ASSESS, THE CASE FOR A PROJECT OR
PROPOSAL, WHICH ITSELF IS A PROCESS KNOWN AS PROJECT
APPRAISAL; AND
AN INFORMAL APPROACH TO MAKING DECISIONS OF ANY KIND.
UNDER BOTH DEFINITIONS THE PROCESS INVOLVES, WHETHER EXPLICITLY OR IMPLICITLY,
WEIGHING THE TOTAL EXPECTED COSTS AGAINST THE TOTAL EXPECTED BENEFITS OF ONE OR
MORE ACTIONS IN ORDER TO CHOOSE THE BEST OR MOST PROFITABLE OPTION

RULE SAYS..

EXAMPLE:

PAYBACK METHOD
PAYBACK MEASURES THE TIME IT WILL TAKE TO RECOUP, IN THE FORM
OF EXPECTED FUTURE CASH FLOWS, THE NET INITIAL INVESTMENT IN A
PROJECT
SHORTER PAYBACK PERIOD ARE PREFERABLE
ORGANIZATIONS CHOOSE A PROJECT PAYBACK PERIOD. THE GREATER
THE RISK, THE SHORTER THE PAYBACK PERIOD
EASY TO UNDERSTAND

PAYBACK METHOD CONTINUED

WITH UNIFORM CASH FLOWS:

WITH NON-UNIFORM CASH FLOWS: ADD CASH FLOWS
PERIOD-BY-PERIOD UNTIL THE INITIAL INVESTMENT IS
RECOVERED; COUNT THE NUMBER OF PERIODS INCLUDED
FOR PAYBACK PERIOD

THE PAYBACK PERIOD METHOD

ADVANTAGES:
IT IS SIMPLE ,BOTH IN CONCEPT AND APPLICATION
ROUGH AND READY MEASURE FOR DEALING IN
RISK
HELPS FIRMS PRESSED WITH PROBLEMS OF
LIQUIDITY

DISADVANTAGES:
IGNORES THE TIME VALUE OF MONEY
IGNORES CASH FLOWS AFTER THE PAYBACK
PERIOD
BIASED AGAINST LONG-TERM PROJECTS
MEASURE OF PROJECTS CAPITAL RECOVERY, NOT
PROFITABILITY
A PROJECT ACCEPTED BASED ON THE PAYBACK
CRITERIA MAY NOT HAVE A POSITIVE NPV

THE DISCOUNTED PAYBACK PERIOD

HOW LONG DOES IT TAKE THE PROJECT TO PAY BACK ITS INITIAL
INVESTMENT, TAKING THE TIME VALUE OF MONEY INTO ACCOUNT?

DECISION RULE: ACCEPT THE PROJECT IF IT PAYS BACK ON A DISCOUNTED

BASIS WITHIN THE SPECIFIED TIME.

THE SHORTER PAYBACK PERIOD, THE MORE DESIRABLE THE PROJECT.

BY THE TIME YOU HAVE DISCOUNTED THE CASH FLOWS, YOU MIGHT AS
WELL CALCULATE THE NPV.

ACCOUNTING RATE OF RETURN

METHOD (ARR)
IT IS A MEASURE OF PROFITABILITY WHICH RELATES INCOME TO
INVESTMENT, BOTH MEASURES IN ACCOUNTING TERMS.
ARR METHOD DIVIDES AN ACCOUNTING MEASURE OF AVERAGE ANNUAL
INCOME OF A PROJECT BY AN ACCRUAL ACCOUNTING MEASURE OF ITS
INVESTMENT.
ALSO CALLED THE ACCOUNTING (AVERAGE) RATE OF RETURN

MEASURES FOR ACCOUNTING RATE OF

RETURN
AVERAGE INCOME AFTER TAX/INITIAL INVESTMENT
AVERAGE INCOME AFTER TAX/AVERAGE INVESTMENT
AVG. INCOME AFTER TAX BUT BEFORE INTEREST/INITIAL INVESTMENT
AVG. INCOME AFTER TAX BUT BEFORE INTEREST/AVG. INVESTMENT
AVG. INCOME BEFORE INTEREST & TAXES/INITIAL INVESTMENT
AVG. INCOME BEFORE INTEREST & TAXES/AVG. INVESTMENT
TOTAL INCOME AFTER TAX BUT BEFORE DEP. INITIAL INVESTMENT/
(INITIAL INVESTMENT/2) *YEAR

ARR METHOD

FIRMS VARY IN HOW THEY CALCULATE ARR

EASY TO UNDERSTAND, AND USE NUMBERS REPORTED IN FINANCIAL
STATEMENTS
DOES NOT TRACK CASH FLOWS
IGNORES TIME VALUE OF MONEY

THANK
YOU