INVESTMENT CRITERIA

PROF. Devinder sehgal

NPV
The Net Present Value of a package of project is simply the of net present values of individuals projects included in the package.

Value of the firm

When a firm makes an acquisition and pays a price in excess of the present value of the expected cash flows from the acquisition it is like taking on a negative NPV project and will diminish the value of the firm.

Limitations of NPV
Advocates of NPV argue that what matters is the surplus value, over and above the hurdle rate, irrespective if what the investment is. The NPV rule does not consider the life of the project. Hence, When mutually exclusive projects with different lives are being considered, the NPV rule is biased in favour of the longer term project.

BENEFIT COST RATIO

BCR=PVB/I
ACCEPT INDIFFERENT REJECT

When BCR>1 When BCR=1 When BCR<1

PROFITABILTY INDEX
Initial investment BENEFITS YEAR 1 YEAR 2 YEAR 3 YEAR 4 1,00,000 25,000 40,000 40,000 50,000

Solution

BCR=1.145

EVALUATION
The proponents of benefit cost ratio argue that since this criterion measures NPV per rupee of outlay , it can discriminate better between large and small investments and hence is preferable to the NPV criterion .

HOW VALID IS THIS ARGUEMENT ?

Under unconstrained conditions , the benefit -cost ratio criterion will accept and reject the same projects as the net present value criterion . When the capital budget is limited in the current period , the benefit-cost ratio criterion may rank projects correctly in the order of decreasingly efficient use of capital . However , its use is not recommended because it provides no means for aggregating several smaller projects into a package that can be compared with a large project . When cash outflows occur beyond the current period , the benefit-cost ratio criterion is unsuitable as a selection criterion .

INTERNAL RATE OF RETURN

1. Determine the net present value of the two closest rates of return . 2. Find the sum of the absolute values of the net present values obtained in step 1 . 3. Calculate the ratio of the net present value of the smaller discount rate , identified in step 1 , to the sum obtained in step 2 . 4. Add the number obtained in step 3 to the smaller discount rate .

THE DECISION RULE FOR IRR

Accept : if the IRR is greater than the cost of the capital . Reject : if the IRR is less than the cost of the capital . --------------------------X----------------------------------

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