Course No.

ET ZC414

Project Appraisal
BITS Pilani
Hyderabad Campus

Module : selection 1 Session 11

S. Hanumantharao Date : 2/28/2015

Total ppt :22

BITS Pilani
Hyderabad Campus

Chapter 8 .. contd
Other Investment Criteria

Objectives
1. Payback period
2. Accounting rate of return
3. Assessment of various methods
4. Investment evaluation in practice

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Payback Period
The payback period is the length of time required to recover
the initial cash outlay on the project.
For example, if a project involves a cash outlay of Rs.600,000
and generates cash inflows of Rs.100,000, Rs.150,000,
Rs.150,000, and Rs.200,000, in the first, second, third, and
fourth years, respectively, its payback period is 4 years
because the sum of cash inflows during 4 years is equal to the
initial outlay.
According to the payback criterion, the shorter the payback
period, the more desirable the project. Firms using this criterion
generally specify the maximum acceptable payback period.
If this is n years, projects with a payback period of n years or
less are deemed worthwhile and projects with a payback
period exceeding n years are considered unworthy.
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Advantages
A widely used investment criterion, the payback period seems to
offer the following advantages:
1. It is simple, both in concept and application. It does not use
involved concepts and tedious calculations and has few
hidden assumptions.
2. It is a rough and ready method for dealing with risk. It favors
projects which generate substantial cash inflows in earlier
years and discriminates against projects which bring
substantial cash inflows in later years but not in earlier years.
Now, if risk tends to increase with futurity - in general, this
may be true - the payback criterion may be helpful in
weeding out risky projects.
3. Since it emphasizes earlier cash inflows, it may be a sensible
criterion when the firm is pressed with problems of liquidity.
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The limitations of the

payback
In its simple version,
it does not consider TVM.
It ignores cash flows beyond payback period.
It measures projects liquidity and not profitability
Cash flows
Cumulative
Year
A
B
A
B
0
-100000
-100000 -100000 -100000
1
50000
20000
-50000
-80000
2
30000
20000
-20000
-60000
3
20000
20000
0
-40000
4
10000
40000
10000
0
5
10000
50000
20000
50000
6
0
60000
20000
110000

Advantages and
Disadvantages of Payback
Advantages
Easy to understand
Adjusts for
uncertainty of later
cash flows
Biased towards
liquidity
ASKS THE WRONG
QUESTION!
It assumes risk tends to increase
with futurity
Does not look at profitability

Disadvantages
Ignores the time value
of money
Requires an arbitrary
cutoff point
Ignores cash flows
beyond the cutoff date
Biased against longterm projects, such as
research and
development, and new
projects

Discounted Payback Period

Year
0
1
2
3
4
5
6
7

Discounting
Cash Flow Factor @
10%
-10,000
1.0000
3,000
0.9091
3,000
0.8264
4,000
0.7513
4,000
0.6830
5,000
0.6209
2,000
0.5645
3,000
0.5132

Cumulative Net
Present Cash Flow After
Value
Discounting
-10,000
2,727
2,479
3,005
2,732
3,105
1,129
1,539

-10,000
-7,273
-4,793
-1,788
944

Looking at the last column in this table, we find

that the discounted payback period is between 3
and 4 years.

Accounting rate of return

7 Different ways of calculation
1. Average income after tax/ Initial investment
2. Average income after tax/ Average investment
3. Average income after tax but before interest/ Initial
investment
4. Average income after tax but before interest/ Average
investment
5. Average income before interest and taxes/ Initial
investment
6. Average income before interest and taxes / Average
investment
7. Total income after tax but before depreciation - Initial
investment/ (Initial investment / 2) x years

Various Measures of Accounting Rate of Return

Income
before
Income
Investment Depreciati Interest and
Before
Year (Book Value)
on
Taxes
Interest Tax
1
1.00
0.20
0.30
0.10
0.20
2
0.80
0.20
0.35
0.10
0.25
3
0.60
0.20
0.40
0.10
0.30
4
0.40
0.20
0.40
0.10
0.30
5
0.20
0.20
0.35
0.10
0.25
Sum
3.00
1.00
1.80
0.50
1.30
Average
0.60
0.20
0.36
0.10
0.26
A
B
C
D
E
F
G

Measures
Average Income After Tax/Initial Investment
Average Income After Tax/Average Investment
Average Income After Tax but Before Interest/Initial
Investment
Average Income After Tax but Before Interest/
Average Investment
Average Income Before Interest and Tax / Initial
Investment
Average Income Before Interest and Tax / Average
Investment
Total Income after Tax but Before Depreciation-Initial
Investment /( Initial Investment/2)*years

Tax
0.100
0.125
0.150
0.150
0.125
0.650
0.130

Income
After
Tax
0.100
0.125
0.150
0.150
0.125
0.650
0.130

13.00%
21.67%

0.13/1
0.13/0.6

23.00%

(0.13+0.1)/1

38.33%

(0.13+0.1)/0.6

36.00%

0.36/1

60.00%

0.36/0.6

26.00%

((0.65+1)-1)/((1/2)*5)

ARR does not take into account the time value of money. To illustrate
this point, consider two investment proposals X and Y, each requiring
an outlay of Rs.100,000.Both the proposals have an expected life of
four years after which their salvage value would be nil.
Accounting Rate of Return Vs. Cash Flow
X
Y

Year

Book
Value

0
1
2
3
4

100,000
75,000
50,000
25,000
0

Depreciai Profit After Cash

Book
ton
Tax
Flow
Value
0
0
100,000 100,000
25,000
40,000 65,000
75,000
25,000
30,000 55,000
50,000
25,000
20,000 45,000
25,000
25,000
10,000 35,000
0

Profit
Depreciait After
on
Tax
0
25,000
25,000
25,000
25,000

0
10,000
20,000
30,000
40,000

Cash
Flow
100,000
35,000
45,000
55,000
65,000

Both the proposals, with an accounting rate of return (measure A) of

40 percent, look
alike from the accounting rate of return point of view, though project
X, because it
provides benefits earlier, is much more desirable. While the payback
period criterion
gives no weight to more distant benefits, the accounting rate of return
criterion seems

ARR and IRR

It is very difficult to generalize if the accounting rate of return is
calculated on the basis of average income over the life of
the project.
However, if the accounting rate of return is calculated for each
year using the expected (or actual) net income, the
following generalizations may be made:
The accounting rate of return tends to understate the internal rate of
return for earlier years and overstate it for later years.
The accounting rate of return and the internal rate of return can be
the same only if the depreciation schedule is equal to the economic
depreciation schedule.
Inflation and creative accounting tend to create a discrepancy
between the accounting rate of return and the internal rate of return.

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Investment evaluation in
practice
A number of surveys have been conducted to learn about the methods of
investment evaluation in practice. Evaluation Techniques in India A
survey of capital budgeting practices in India, conducted by U.Rao
Cherukeri, revealed the following:
1. Over time, discounted cash flow methods have gained in importance and
internal rate of return is the most popular evaluation method.
2. Firms typically use multiple evaluation methods.
3. Accounting rate of return and payback period are widely employed as
supplementary evaluation methods. .
4. Weighted average cost of capital is the most commonly used discount
rate and the most often used discount rate is 15 percent in post-tax
terms.
5. Risk assessment and adjustment techniques have gained popularity. The
most popular risk assessment technique is sensitivity analysis and the
most common methods for risk adjustment are shortening of the payback
period and increasing the required rate of return.
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Investment evaluation in
practice
A survey of corporate finance practices in India by Manoj Anand,
reported in the October- December 2002 issue of Vikalpa

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Evaluation techniques in the

U.S
Findings of a study conducted by William Petty and David
Scott are as shown below

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Evaluation Techniques in
Japan
Japanese firms appear to rely mainly on two kinds of analysis: (a) one
year return on investment analysis and (b) residual investment analysis.
There is a great deal of consensus decision making in Japanese firms
which necessarily calls for the use of relatively simpler methods.
Japanese firms put considerable emphasis on verbal scenario analysis
(as opposed to complex calculations) and careful scrutiny of basic
assumptions which seems to blend well with a healthy skepticism about
the accuracy of quantitative forecasts.

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Various Investment criteria

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.
NPV has certain properties that make it a very attractive
decision criterion: NPVs are additive; the NPV rule
assumes that the intermediate cash flows of a project are
reinvested at a rate of return equal to the cost of capital;
NPV calculation permits time varying discount rates.
Reinvestment rates applicable to the intermediate cash
flows need to be defined for calculating the modified net
present value.

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Various Investment criteria

Profitability Index or BCR
The benefit cost ratio is defined as the present value of
benefits (cash inflows) divided by the present value of
costs (cash outflows).
A project is considered worthwhile if the benefit cost ratio
is more than 1 and not worthwhile if the benefit cost ratio
is less than 1.

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Various Investment criteria

IRR
The internal rate of return (IRR) of a project is the
discount rate which makes its NPV equal to zero.
When cash flow is negative after generating positive
inflows, we may have more than one value for IRR
Comparing IRR between projects can lead to misleading
results if the initial investment or temporal patterns are
different.
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.
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Various Investment criteria

Payback Period
The payback period is the length of time required to
recover the initial cash outlay on the project.
Discounted payback period cash flows are first
converted into their present values
It measures capital recovery, not profitability.
Payback period is normally used to determine if detailed
analysis is required.

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Various Investment criteria

Accounting rate of return
Accounting rate of return does not evaluate cash flows and
is based on comparing profit to investment.
It considers benefits over the entire life of the project.
It does not consider the time value of money.
It differs from IRR in its treatment of depreciation and book
value of investment.
Since the book value of assets tends to be high in the initial
years and income generated by a long term project will be
higher in the later Years, AAR will be lower than IRR in the
initial years.
AAR is normally used to determine if detailed analysis is
required.
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Use of various Investment

criteria
The most popular methods for evaluating small sized
projects are payback method and accounting rate of
return method.
For larger projects, IRR appears to be the most
commonly used method.
When IRR gives a problem, NPV is used.
In the U.S., internal rate of return, net present value,
accounting rate of return, and payback period are the
most popular methods of project appraisal.
Japanese firms appear to rely mainly on two kinds of
analysis: (i) one year return on investment analysis, and
(ii) residual investment analysis.
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