INVESTMENT

CRITERIA
CHAPTER 8 TEXTBOOK T2

FINANCIAL FEASIBILITY OF
PROJECTS
ESTIMATE THE COSTS AND BENEFITS OF THE

PROJECT
ASSESS THE RISKINESS OF THE PROJECT
CALCULATE THE COST OF CAPITAL
COMPUTE THE CRITERIA OF MERIT
JUDGE THE PROJECT IS GOOD OR BAD

COST OF CAPITAL
IT IS THE WEIGHTED AVERAGE COST OF VARIOUS

SOURCES OF FINANCE FOR THE FIRM

EXAMPLE:
COST OF EQUITY = 16%
PROPORTION =
50%
COST OF PREFERENCE = 12% PROPORTION=
40%
COST OF DEBT = 8%
PROPORTION =
10%
COST OF CAPITAL = (16X0.5) + (12X0.4) +
(8X0.1)=12.4%

SELECTION CRITERIA
FINANCIAL MODELS: PREFERRED METHOD TO

EVALUATE PROJECTS
PAY

BACK PERIOD (in years) : ESTIMATED

PROJECT COSTS / ANNUAL SAVINGS
RETURN ON INVESTMENT (in %)
NET PRESENT VALUE (NPV) : uses time value of
money, cash flows and profitability

NON-FINANCIAL CRITERIA: STRATEGIC, LESS

TANGIBLE, RESTORE CORPORATE

ENHANCE BRAND RECOGNITION

IMAGE,

MULTI-CRITERIA SELECTION
MODELS
CHECKLIST MODEL:
LIST OF QUESTIONS TO REVIEW POTENTIAL PROJECTS
DETERMINE ACCEPTANCE OR REJECTION
FLEXIBILITY

IN SELECTING DIFFERENT PROJECTS

WITH SOME VARIATIONS IN QUESTIONS
FAILS TO ANSWER THE RELATIVE IMPORTANCE OR
VALUE OF POTENTIAL PROJECT
FAILS TO ALLOW COMPARISON WITH OTHER
POTENTIAL PROJECTS
ROOM FOR POWER PLAY, POLITICS, MANIPULATION

MULTI WEIGHTED SCORING

MODELS
QUALITATIVE OR QUANTITATIVE CRITERIA
EACH SELECTION CRITERIA IS ASSIGNED A

WEIGHT
SCORES ARE ASSIGNED TO EACH CRITERION
FOR THE PROJECT BASED ON ITS IMPORTANCE
WEIGHTS AND SCORES ARE MULTIPLIED TO
GET TOTAL WEIGHTED SCORE FOR THE
PROJECT
PROJECTS
WITH HIGHER SCORES ARE
CONSIDERED BETTER

EXAMPLE
CRITERION

WEIGHTAGE
A. STAY WITH CORE COMPETENCIES
2.0
B. STRATEGIC FIT
3.0
C. URGENCY
2.0
D. 25% OF SALES FROM NEW PRODUCTS 2.5
E. REDUCE DEFECTS TO LESS THAN 1%
1.0
F. IMPROVE CUSTOMER LOYALTY
1.0
G. ROI OF 18% +
3.0

CONTRIBUTION VALUES TO EACH

CRITERION FOR EACH PROJECT
PROJECT
1
2
3
4

B
1
3
3
1

C
D
8
2
3
2
0 10
10
5

E
6
0
0
10

F
0
0
0
0

G
WT. TOTAL
6 5
66
5 1
27
6 0
32
8 9
102

HIGHEST PRIORITY : PROJECT 4, THEN PROJECT 1

PROJECT SCREENED OUT : PROJECT 2 AND 3, IF

CRITERION IS WEIGHTED TOTAL SHOULD BE MORE

THAN 50

APPLYING A SELECTION
MODEL
PROJECT

CLASSIFICATION: PROJECTS FIT TO

ORGANIZATIONS STRATEGY
SELECTING A MODEL: MULTIPLE CRITERIA TO
SELECT THE PROJECT
BEST USE OF HUMAN AND CAPITAL RESOURCES
TO MAXIMIZE RETURN ON INVESTMENT IN THE
LONG RUN
RESEARCHING NEW TECHNOLOGIES, PUBLIC
IMAGE, ETHICAL POSITION, PROTECTION OF
ENVIRONMENT, CORE COMPETENCIES, STATEGIC
FIT

CATEGORIES OF INVESTMENT
CRITERIA
DISCOUNTING CRITERIA
NET PRESENT VALUE (NPV)
BENEFIT COST RATIO (BCR)
INTERNAL RATE OF RETURN (IRR)
NON-DISCOUNTING CRITERIA
PAYBACK PERIOD
ACCOUNTING RATE OF RETURN

NET PRESENT VALUE

(NPV)
NPV 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 = Ct / (1 + r ) n - Investment
for the period t=1 to t=n
where Ct = cash flow at the end of year t
n = life of the project
r = discount rate
IT IS THE NET BENEFIT OVER AND ABOVE THE
COMPENSATION FOR TIME AND RISK

ACCEPT THE PROJECT IF NPV IS POSITIVE

REJECT THE PROJECT IF NPV IS NEGATIVE

PROPERTIES
VALUE OF FIRM =
PRESENT VALUE OF
PROJECTS + NET PRESENT VALUE OF
PROSPECTIVE PROJECTS
WHEN A FIRM TERMINATES AN EXISTING
PROJECT WHICH HAS NEGATIVE NPV BASED
ON ITS EXPECTED FUTURE CASH FLOWS, THE
VALUE OF FIRM INCREASES BY THAT AMOUNT

WHEN A FIRM DIVESTS ITSELF OF AN EXISTING PROJECT AND

THE PRICE IS GREATER/LESSER THAN THE PRESENT VALUE OF

THE ANTICIPATED CASH FLOWS OF THE PROJECT, THE VALUE OF
FIRM WILL INCREASE/DECREASE WITH THE DIVESTITURE
WHEN A FIRM TAKES ON A NEW PROJECT WITH POSITIVE NPV,

THE VALUE OF FIRM MAY DROP IF NPV IS NOT IN LINE WITH THE
HIGH EXPECTATION OF INVESTORS
WHEN A FIRM MAKES AN ACQUISITION AND PAYS A PRICE IN

EXCESS OF THE PRESENT VALUE OF THE EXPECTED CASH

FLOWS FROM THE ACQUISTION IT IS TAKING ON A NEGATIVE
NPV PROJECT AND HENCE WILL DIMINISH THE VALUE OF THE
FIRM

INTERMEDIATE CASH FLOWS ARE

INVESTED AT COST OF CAPITAL
CASH FLOWS THAT OCCUR BETWEEN THE

INITIATION AND THE TERMINATION OF THE

PROJECT ARE INVESTED AT A RATE OF RETURN
EQUAL TO THE COST OF CAPITAL

NPV CALCULATIONS PERMITS TIME

VARYING DISCOUNT RATES
NPV = Ct / (1 + ri)n - Initial Investment
NPV

OF A SIMPLE PROJECT STEADILY

DECREASES
AS
THE
DISCOUNT
RATE
INCREASES

EXAMPLE 1
YEAR

0
1
2
3
4
5
COST

CASH FLOW
(1,000,000)
200,000
200,000
300,000
300,000
350,000
OF CAPITAL = r = 10%

NPV = - 1,000,000 + 200,000 + 200,000 +

(1.10)0

(1.1)1

300,000 + 300,000 + 3, 50,000

(1.1) 5
(1.1)3
(1.1)4
= - Rs. 5272

(1.1)2

EXAMPLE 2
YEAR

0
1
2
3
4
5

CASH FLOW
(12000)
4000
5000
7000
6000
5000

DISCOUNT RATE
14%
15%
16%
18%
20%

SOLUTION
NPV = -12000 + 4000 +

5000______ +
(1.14)
(1.14)(1.15)
7000___________ + 6000________________ +
(1.14)(1.15)(1.16)
(1.14)(1.15)(1.16)(1.18)
5000________________ = 5592
(1.14)(1.15)(1.16)(1.18)(1.20)

MODIFIED NET PRESENT

VALUE
CALCULATE THE TERMINAL VALUE OF THE

PROJECTS
CASH
INFLOWS
USING
REINVESTMENT
RATE
THAT
REFLECTS
PROFITABILITY OF INVESTMENT
TV = CFi (1 + r)n-t

TV is the terminal value of the projects

cash inflows, CFi is the cash inflow at the end
of year t and r is the reinvestment rate

Where

NPV = TV / (1 + r)n - Investment Outlay

Project X
Project Y
Investment Outlay
110,000
110,000
Year 1
31,000
71,000
Year 2
40,000
40,000
Year 3
50,000
40,000
Year 4
70,000
20,000
Re-investment rate = 14% and 20%

Project X
(TV) 14% = 224,911
(TV) 20% = 241,168

NPV = 43,614
NPV = 54,717

Project Y
(TV) 14% = 222, 774
(TV) 20% = 248, 288

NPV = 42,158
NPV = 59,584

BENEFIT COST RATIO

BENEFIT COST RATIO (BCR) = (PVB) / I
PVB = PRESENT VALUE OF BENEFITS
I = INITIAL INVESTMENT
NET BENEFIT COST RATIO (NBCR) = BCR 1
BCR
NBCR
RULE
>1
>0
ACCEPT
=1
=0
INDIFFERENT
<1
<0
REJECT

EXAMPLE 3
INITIAL INVESTMENT (I) : 100,000
YEAR 1
25000
YEAR 2
40000
YEAR 3
40000
YEAR 4
50000
BCR = PVB / I
r = 12%
BCR = 1.145
NBCR = 0.145

INTERNAL RATE OF RETURN (IRR)

IRR IS THE DISCOUNT RATE WHICH MAKES

NPV EQUAL TO ZERO

INVESTMENT = Ct / (1 + r)t

for t = 1 to t = n

ACCEPT : IF THE IRR IS GREATER THAN THE

COST OF CAPITAL
REJECT : IF THE IRR IS LESS THAN THE COST
OF CAPITAL

EXAMPLE 4
YEAR

0
1
2
3
4

CASH FLOW
(100,000)
30,000
30,000
40,000
45,000

1,00,000 = 30000/(1+r) + 30000 / (1+r) 2 +

40000/(1+r)3 + 45000/(1+r)4

Find r using trial and error method.

Determine the net present value of the two

closest rates of return

Find the sum of absolute values of the net
present value
Calculate the ratio of net positive value of the
smaller discount rate to the sum of absolute
values
Add the number obtained above to the
smaller discount rate

r = 15% NPV = 802

r= 16% NPV = -1359
Sum of absolute values = 2161
Ratio = 802 / 2161 = 0.37
IRR = 15 + 0.37 = 15.37%
If cost of capital is say 10%, then accept the

project

MODIFIED INTERNAL RATE OF

RETURN (MIRR)
CALCULATE THE PRESENT VALUE OF THE

COSTS (PVC) USING THE COST OF CAPITAL AS

THE DISCOUNT RATE
PVC = CASH OUTFLOW / (1+r)t
CALCULATE THE TERMINAL VALUE OF THE
CASH INFLOWS EXPECTED FROM THE PROJECT
TV = CASH INFLOW (1 + r)n-t
PVC = TV / (1+MIRR)n

EXAMPLE 5
YEAR

0
1
2
3
4
5
6
Cost of Capital = 15%

CASH FLOW
- 120
- 80
20
60
80
100
120

Solution
PVC = 120 + 80/(1.15) = 189.6
TV = 20(1.5)4 + 60 (1.15)3+ 80 (1.15)2 + 100

(1.15) + 120 = 467

189.6 = 467 / (1 + MIRR)6
MIRR = 16.2%

PAYBACK PERIOD
LENGTH OF TIME REQUIRED TO RECOVER THE

INITIAL CASH OUTLAY ON THE PROJECT

SHORTER THE PAYBACK PERIOD, MORE
DESIRABLE IS THE PROJECT

ADVANTAGES
IT

IS SIMPLE BOTH IN CONCEPT AND

APPLICATION
IT FAVORS PROJECTS WHICH GENERATE
SUBSTANTIAL CASH INFLOWS IN EARLIER
YEARS
AND
DISCRIMINATES
AGAINST
PROJECTS WHICH BRINGS CASH INFLOWS IN
LATER YEARS
IT IS USEFUL WHEN COMPANY IS PRESSED
WITH PROBLEMS OF LIQUIDITY

LIMITATIONS
IT FAILS TO CONSIDER THE TIME VALUE OF

MONEY
IT IGNORES CASH FLOWS BEYOND THE
PAYBACK PERIOD
IT IS A MEASURE OF PROJECTS CAPITAL
RECOVERY, NOT PROFITABILITY
IT MEASURES A PROJECTS LIQUIDITY BUT
DOES NOT INDICATE LIQUIDITY POSITION OF
THE FIRM AS A WHOLE

DISCOUNTED PAYBACK
PERIOD
IT TAKES INTO ACCOUNT TIME VALUE OF

MONEY
CASH FLOWS ARE CONVERTED TO THEIR
PRESENT VALUES BY APPLYING DISCOUNTING
FACTORS
FIND THE CUMULATIVE NET CASH FLOW
AFTER DISCOUNTING TILL WE GET POSITIVE
VALUE
THE CORRESPONDING PERIOD SHOWS THE
DISCOUNTED PAYBACK PERIOD

EXAMPLE 6
YEAR

CASH FLOW PRESENT VALUE CUM.

0
-10000
-10000
-10000
1
3000
2727
-7273
2
3000
2478
-4795
3
4000
3004
-1791
4
4000
2732
941
5
5000
3105
6
2000
1130
Assuming r = 10% Discounted Payback Period =
Between 3 and 4 years, say around 3.5 years

ACCOUNTING RATE OF
RETURN
IT IS THE AVERAGE RATE OF RETURN ON

INVESTMENT AND IS A MEASURE OF

PROFITABILITY
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 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 * YEAR)

HIGHER THE ACCOUNTING RATE OF RETURN,

THE BETTER THE PROJECT

PROBLEM 1 / PAGE 8.29

YEAR

CASH FLOW
0 - 1000,000
1
100,000
2
200,000
3
300,000
4
600,000
5
300,000
Part A : Taking r = 14%
Part B : Taking r=12% and then 1% increase every
year

PART A
NPV = -1000000 + 100000/(1.14) + 200000/

(1.14)2 + 300000/(1.14)3 + 600000/(1.14)4 +

300000/(1.14)5
= - Rs. 44837
PART B
NPV = -1000000 + 100000/(1.12) + 200000/
(1.12)(1.13) + 300000/(1.12)(1.13)(1.14) +
600000/(1.12)(1.13)(1.14)(1.15) + 300000/
(1.12)(1.13)(1.14)(1.15)(1.16) = - Rs. 27265

PROBLEM 2, PAGE 8.29

CURRENT OUTLAY = 300000
ANNUAL CASH FLOW OF Rs. 60000 FOR 7

YEARS
300000 = 60000/(1+r) + 60000/(1+r) 2 +
60000/(1+r)3 + 60000/(1+r)4 + 60000/(1+r)5
+ 60000/(1+r)6
+ 60000/(1+r)7

Trial and Error Method

Take r = 10
292105
-7895

r=9
304165
4165
Sum of absolute values = 12060
Ratio = 4165/12060 = 0.345
IRR = 9 + 0.345 = 9.345