Session 6 Financing Investment Criteria V D Shikhare

Investment Criteria
Discounting criteria
Net Present Value Benefit Cost Ratio Internal Rate of Return

Non-discounting criteria
Payback Period Accounting Rate of Return

Net Present Value

NPV of a Project: Sum of the present values of all the

cash flows (+ve and ve) expected over the life of project Represent net benefit over and above the compensation for time and risk Project is acceptable if NPV is positive and rejected if NPV is negative

NPV - calculation
The cost of capital for the firm is 10%
Ye ar
0 1 2 3 4

Cash flow
(1,000,000) 200,000 200,000 300,000 300,000

Present value factor

1 / (1.10)0 + 1 / (1.10)1 + 1 / (1.10)2 + 1 / (1.10)3 + 1 / (1.10)4

350,000 NPV

+ 1 / (1.10)5 Rs 5273

Benefit Cost ratio or Profitability Index

Two ways of defining

PVB BCR = ------------------I

Net Cost Benefit Ratio NBCR = ----------- = BCR I

PVB - I

Where PVB is the present value of benefits and I is

initial investment. Decision Rule if BCR > 1 or NBCR > 0 Accept

Evaluation of BCR
The criterion measures net present value per rupee of

outlay. It can distinguish between large and small investments. 1. The BCR criterion will accept or reject the same projects as NPV if there are no other constraints 2. If capital budget is limited the BCR criterion will rank projects as per efficient use of capital invested. 3. BCR has no means of aggregating smaller projects 4. Unsuitable for cash outflows beyond current period.

Internal Rate of Return (IRR)

IRR is the Discount rate which makes Project NPV equal to

zero. n
INVESTMENT =

---------- t t = 1 (1 + r)

ct

Ct is the cash flow at the end of year t R is the internal rate of Return IRR (found by trial & error) n is the life of project in years Decision Rule Accept:

Reject:

if IRR is > cost of capital if IRR is < cost of capital

Evaluation of IRR
IRR and NPV rules will lead to identical decisions when

Cash flows are conventional (-ve initially and later +ve) 2. Project must be independent and can be accepted or rejected without reference to any other project
1.
Project P Q Cash Flow C0 -10000 -50000 C1 20000 75000 100% 50% IRR NPV r = 12% 7857 16964

Not reliable for ranking projects of different scale 4. Does not distinguish between lending and borrowing
3.

Meaning of IRR
The internal rate of return represents the rate of return on

unrecovered investment balance in the project. The internal rate of return is the rate of return earned on the initial investment made in the project IRR is popular as a measure 1. Financial analysts think in terms of rates of return 2. IRR can be interpreted by all parties 3. Can be mentally compared with inflation, current borrowing rate, cost of capital, return on equity portfolio etc. 4. You cannot compute NPV unless you have discount rate.

PAYBACK PERIOD
Defined as Length of time required to recover initial outlay Projects with shorter payback period are more attractive Criterion of maximum acceptable payback period Evaluation: Simple in concept and application Rough and ready method for dealing with risk Sensible criterion when there are problems of liquidity

Payback Period
Limitations Does not consider time value of money Ignores cash flows beyond payback period Measure of capital recovery and not profitability - Discounted Payback period can be calculated! Payback period is popular as Reciprocal of IRR when annual cash inflow is constant Conveys the rate at which uncertainty is resolved. Ths helps decision maker to take prompt corrective action.

Accounting Rate of return

Also referred to as average rate of return. It can be measured in

different ways Various Measures of Accounting Rate of Return

Year Investme nt (book value) Deprec iation Income before interest and taxes Inter est Income before tax Tax Income after tax

1 2 3 4 5 Aver age

1.00 0.80 0.60 0.40 0.20 0.60

0.20 0.20 0.20 0.20 0.20 0.20

0.30 0.35 0.40 0.40 0.35 0.36

0.10 0.10 0.10 0.10 0.10 0.10

0.20 0.25 0.30 0.30 0.25 0.26

0.10 0.125 0.150 0.150 0.125 0.130

0.100 0.125 0.150 0.150 0.125 0.130

Accounting Rate of Return

A:
B: C:

Average income after tax = 0.13 = 13.0%

Initial Investment 1.00

D:

Average income after tax = 0.13 = 21.7% Average investment 0.60 Average income after tax but before interest = Initial investment = 0.13+0.10 = 23.0% 1.0

Measures of accounting rate of return A 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 tax and interest Initial investment Average income before tax and interest F Average investment = 0.13 = = 13% 1 0.13 = = 21.70% 0.6 0.13 + 0.10 = = 23% 1 0.13 + 0.10 = = 38.30% 0.6

B
C D E

0.36
= 1 0.36 0.6 = 36%

= 60%

Total income after tax but before depreciation 0.65+1.00initial investment = 1.00 = 26% (Initial investment / 2) x Years x5

Accounting rate of return

It is simple to calculate It is based on accounting information which is readily

available and familiar to businessmen Obtained from the financial accounting system which facilitates post-auditing of project expenditures Can be calculated even if the income data for entire life of project is not available Shortcomings It is based on accounting profit and not cash flow Does not take time value of money into account

Assignment 2 to be submitted by March 4, 2013

Your company is considering two projects, Project M and Project N, each of which requires an initial investment of Rs 50 million. The expected cash inflows from these projects are
Year 1 2 3 Project M Rs Million 11 19 32 Project N Rs Million 38 22 18

4
a) b)

37

10

c)
d) e)

What is the payback period for each of the projects? What is the discounted payback period for each of the projects if the cost of capital is 12% If the two projects are independent and the cost of capital is 12%, which project(s) should the firm invest in? If the two projects are mutually exclusive and the cost of capital is 10%, which project should the firm invest in? If the projects are mutually exclusive and the cost of capital is 15%, which project should the firm invest in?

Thank You