Introduction to Investment Criteria

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Introduction to Investment Criteria

• Need specific criteria to make decisions.
• Review a number of alternatives and discuss pros
  and cons.
• Generally focus on making investment decisions,
  not financing decisions.

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Qualities of a Good Criteria

• Includes all relevant cash flows.
• Incorporates Time Value of Money.
• Accounts for risk of cash flows.
• Maximizes shareholder value.

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Commonly Used Criteria

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
• Payback Period
• Discounted Payback
• Accounting Returns

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Core Example

• 1000 initial investment.
• 500 cash flow per year for 10 years.
• 5000 terminal expense in year 10.
• 12 discount rate.

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Net Present Value

• Essentially same analysis as DCF.
• NPV PV(Cash Flows) - Initial Investment
• Discounting is done at a rate consistent with the
  risk of the cash flows.
• Decision Rule Accept if NPV gt 0

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NPV Example

• To find the net present value, discount all
  future cash flows and subtract the initial
  investment.
• Since NPV gt 0, you should accept this project.

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Internal Rate of Return

• Similar to NPV, but solves for discount rate that
  makes NPV zero.
• Decision Rule Accept if IRR gt hurdle rate
• Good idea, but there are some limitations
• Multiple IRRs
• Ignores scale of project (mutually exclusive
  projects)

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IRR Example

• Since NPV gt 0 at 12, NPV 0 at gt 12.
• Using a financial calculator or trial-and-error,
  NPV 0 at 42.3.
• Verify this solution by pulgging it in the
  formula.

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IRR Flaw Multiple IRRs

• In this example, there is actually a second
  discount rate, 7.4, that makes the NPV0.

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IRR Flaw Mutually Exclusive Projects

• Consider two mutually exclusive projects
• A has a 2500 initial outlay and pays 500 per
  year for 10 years.
• B has a 200 initial outlay and pays 50 annually
  for 10 years.
• At a 12 discount rate, which one do you choose?
• IRRA 15 IRRB 21
• But NPVA 325 NPVB 83

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Profitability Index

• Same idea as NPV, but an index instead of a
  dollar amount.
• PI PV(Cash Flows)/Initial Investment
• Decision Rule Accept if PI gt 1
• Problems
• Ignores scale of projects
• Harder to interpret than NPV

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PI Example

• Returning to the core example
• Since PI gt 1, accept the project.
• Note that there are no units, it is an index.

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PI Flaw Ignores Scale

• Recall the projects A and B.
• We saw that
• NPVA 325 NPVB 83
• IRRA 15 IRRB 21
• The PI for each project is
• PIA 1.13 PIB 1.41
• Like IRR, PI ignores the scale of the project.

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Payback Period

• Idea Measure how long it takes to recover
  investment,
• Decision Rule Accept if Payback Period lt hurdle
  period
• Problems
• Completely ignores TVM
• Largely ignores risk of cash flows
• Completely ignores any CF after Payback Period
• Arbitrary hurdle period
• Biased towards short-term investments

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Payback Period Example

• To recover the 1000 investment in the core
  example,
• Year 1 500
• Year 2 500
• It takes 2 years to recover the investment.
• You would accept the project based on this
  criteria if the hurdle payback period is at least
  2 years.

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Payback Flaw Ignores TVM

• The present value of the first 2 payment is less
  than 1000 because of TVM.
• This rule would give the same decision if the
  first two payments were
• 0 in year 1, 1000 in year 2
• 500 in year 1, 500 in year 2
• 999 in year 1, 1 in year 2

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Payback Flaw Ignores CF Risk

• This method also basically ignores the risk of
  the cash flows since there is no way to formally
  include it in the analysis.
• By ignoring distant cash flows altogether, there
  is some sense in which risk is considered.

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Payback Flaw Ignores Distant CF

• What if the cutoff period is 5 years and cash
  flows are 1000 initial investment, 0 for the
  next 5 years and 1 million in year 6?
• The payback method would reject this project
• The IRR is over 215.
• NPV would be large and positive at any reasonable
  discount rate.

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Payback Flaw Arbitrary Hurdle

• In the prior example, if the cutoff was 6 years
  we would take the project.
• There is really no good way to determine an
  appropriate payback period hurdle.

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Payback Flaw Short-term Bias

• The criteria is naturally biased against
  long-term projects.
• This is a serious problem that can lead to
  under-investment and it does not maximize
  shareholder value.

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Discounted Payback

• Accounts for TVM and CF risk by discounting Cash
  Flows
• Still suffers from other weaknesses of Payback
  Method

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Discounted Payback Example

• Adding up the discounted cash flows, the initial
  investment is recovered in the third year.

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Accounting Returns

• Common measures are ROA and ROE
• Flaws
• Ignores TVM
• Ignores future performance
• Uses accounting figures, not cash flows

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