Investment Decision Rules

Concepts and calculation

Ritesh Pandey

September 22, 2020

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Types of decision rules

1 Non-discounting rules
1 Accounting Rate of Return
2 Payback Period
2 Discounting-based rules
1 Discounted Payback Period
2 Net Present Value
3 Internal rate of Return
4 Profitability Index (Benefits-Costs Ratio)

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 Accounting rate of return rule

Table of Contents

1 Accounting rate of return rule

2 Payback period rule

3 Discounted payback period rule

4 Net present value rule

5 Internal rate of return rule

6 Profitability index/Benefits-costs ratio rule

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 Accounting rate of return rule

Accounting rate of return (ARR) rule

1 Accept the project or investment if it has a high, positive ARR.

2 Choose a project which has a relatively higher ARR over others

with lower ARR.

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 Accounting rate of return rule

Accounting rate of return (ARR) computation

Average Annual PAT

ARRon initial investment = × 100
Initial Investment

Average Annual PAT

ARRon average investment = × 100,
Average Investment
where,

Initial Investment + Closing Balance

Average investment = .
2

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 Accounting rate of return rule

Accounting rate of return (ARR) computation

1 If investment has some salvage value (scrap/residual value)

then:
1 Subtract salvage value from initial investment and apply
depreciation to this amount.

Initial Investment + Salvage Value

2 Average investment = .
2

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 Accounting rate of return rule

Accounting rate of return (ARR) computation

2 If additional working capital has been infused in the project

then:
1 This implies an addition to the total investment in the project.

2 The investment in working capital is assumed to be fully

recovered at the end of the project. So:

Initial Investment + Salvage Value + Recovered Working Capital

3 Average investment = .
2

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 Accounting rate of return rule

Example of ARR criterion

Accounting rate of return example

Question: Find out the ARR for each of the two projects shown below. Which is the
preferred project?

Expected after-tax net cash flows (|)

Year Project 1 Project 2
0 -1000 -1000
1 500 100
2 400 300
3 300 400
4 100 600
Total inflows 1300 1400

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 Accounting rate of return rule

Example of ARR criterion

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 Accounting rate of return rule

Merits and demerits of ARR criterion

1 Merits
1 Easy to understand
2 Easy to compute
2 Demerits
1 Uses accounting numbers and not cash flows
2 Ignores time value of money
3 No conceptually sound cutoff between acceptable and unacceptable
projects
4 Can be computed in more than one ways

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 Payback period rule

Table of Contents

1 Accounting rate of return rule

2 Payback period rule

3 Discounted payback period rule

4 Net present value rule

5 Internal rate of return rule

6 Profitability index/Benefits-costs ratio rule

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 Payback period rule

Payback period rule

1 Accept the project or investment if it has a short payback

period.

2 Choose a project which has a relatively shorter payback period

over others with longer payback periods.

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 Payback period rule

Payback period computation

1 Payback period is the number of periods required to recover the

initial investment in a project.

2 Clearly, the shorter the payback period, the better the project.

3 For a project with an initial investment and constant cash flows,

Initial investment
Payback period =
Annual cash inflow

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 Payback period rule

Payback period computation

In general,
Unrecovered cost at the start of year
Payback period = Years before full recovery +
Cash flow during year

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 Payback period rule

Payback period computation

1 In case there is some salvage value, depreciation is applied to initial

investment minus its salvage value and salvage value is added to
initial investment to get average investment.

2 In case any additional working capital is infused in the project, extra

working capital for a particular year is a cash outflow for that year;
any working capital recovered in the last year is a cash inflow for the
last year.

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 Payback period rule

Merits and demerits of payback period criterion

1 Merits
1 Easy to understand
2 Easy to compute
3 Based on cash flows (a plus point over ARR)
4 Gives an idea of the risk in and liquidity of a project
2 Demerits
1 Does not consider cashflows beyond payback period
2 Does not consider timing of the cash flows
3 So, it is a measure of payback and not a measure of profitability

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 Payback period rule

Example of payback period criterion

Payback period example

Question: Find out the payback period for each of the two projects shown below. Which
is the preferred project?

Expected after-tax net cash flows (|)

Year Project 1 Project 2
0 -1000 -1000
1 500 100
2 400 300
3 300 400
4 100 600
Total inflows 1300 1400

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 Payback period rule

Example of payback period criterion

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 Discounted payback period rule

Table of Contents

1 Accounting rate of return rule

2 Payback period rule

3 Discounted payback period rule

4 Net present value rule

5 Internal rate of return rule

6 Profitability index/Benefits-costs ratio rule

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 Discounted payback period rule

Discounted payback period rule

1 Accept the project or investment if it has a short discounted

payback period.

2 Choose a project which has a relatively shorter discounted

payback period over others with longer discounted payback
periods.

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 Discounted payback period rule

Discounted payback period computation

1 Discounted payback period is the number of years it takes for the

cumulative discounted cash flows from a project to equal the initial
investment in a project.

2 Clearly, the shorter the discounted payback period, the better the
project.

3 If a project has a negative NPV, it will usually not have a discounted

payback period since it never recovers its initial investment.

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 Discounted payback period rule

Example of discounted payback period criterion

Discounted payback period example

Question: Find out the discounted payback period for each of the two projects shown
below. Assume that the opportunity cost of capital for both projects is 10%. Which is
the preferred project?

Expected after-tax net cash flows (|)

Year Project 1 Project 2
0 -1000 -1000
1 500 100
2 400 300
3 300 400
4 100 600
Total inflows 1300 1400

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 Discounted payback period rule

Example of discounted payback period criterion

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 Discounted payback period rule

Merits and demerits of discounted payback period criterion

1 Merits
1 Based on cash flows
2 Gives an idea of the risk in and liquidity of a project
3 Takes into account the time value of money
2 Demerits
1 Does not consider cashflows beyond discounted payback period
2 So, it is a measure of payback and not a measure of profitability
3 What if the cash flows beyond the discounted payback period become
negative? The project may have a reasonable discounted payback
period but a negative NPV simultaneously.

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 Discounted payback period rule

Comparison of discounted and undiscounted payback

period criteria

Discounted vs undiscounted payback period example

Question: Find out the normal as well as discounted payback periods for each of the two
projects shown below. Assume that the opportunity cost of capital for both projects is
10%. Which is the preferred project?

Expected after-tax net cash flows (|)

Year Project 1 Project 2
0 -3000 -3000
1 1000 0
2 1000 0
3 1000 0
4 1000 10,00,000
Total inflows 4000 10,00,000

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 Discounted payback period rule

Example of discounted payback period criterion

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 Discounted payback period rule

Example of discounted payback period criterion

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 Net present value rule

Table of Contents

1 Accounting rate of return rule

2 Payback period rule

3 Discounted payback period rule

4 Net present value rule

5 Internal rate of return rule

6 Profitability index/Benefits-costs ratio rule

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 Net present value rule

NPV rule

1 Accept the project or investment if its NPV is positive.

Choosing the project is then equivalent to receiving its NPV in
cash today.

2 Choose a project which has a greater positive NPV over others

with smaller positive NPVs.

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 Internal rate of return rule

Table of Contents

1 Accounting rate of return rule

2 Payback period rule

3 Discounted payback period rule

4 Net present value rule

5 Internal rate of return rule

6 Profitability index/Benefits-costs ratio rule

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 Internal rate of return rule

Internal rate of return rule

1 Accept the project or investment if its IRR > hurdle rate.

2 Choose a project which has a greater IRR over others with

smaller IRRs.

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 Internal rate of return rule

Internal rate of return rule

1 The hurdle rate is a required rate of return that is set as a

target by the investors or by the firm undertaking the project.
It could be the opportunity cost of capital for the project, for
instance.

2 Whan a firm accepts projects for which the IRR exceeds the
cost of capital incurred in financing the project, a surplus will
remain after paying the investors of capital and this will accrue
to the shareholders of the firm.

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 Internal rate of return rule

IRR computation

1 The Internal Rate of Return of a project or investment is that

discount rate which equates the PV of its expected benefits with the
PV of its expected costs.

2 Clearly, the IRR is that discount rate at which its NPV equals zero.

3 At r = IRR, PV (Cash inflows) = PV (Cash outflows).

n
X Ci
So, =0
(1 + IRR)t
t=0

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 Internal rate of return rule

IRR computation by interpolation

NPV by LR
IRR = LR + × (HR − LR)
PV by LR − PV by HR

Here, LR (lower rate) is a discount rate at which NPV is positive and HR

(higher rate) is a discount rate at which NPV is negative.

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 Internal rate of return rule

Merits and demerits of IRR criterion

1 Merits
1 Based on cash flows
2 Takes into account the time value of money
3 The IRR gives us a measure of the average return over the life of an
investment.
4 The IRR also indicates the sensitivity of the NPV to estimation errors
in the cost of capital.
2 Demerits
The IRR rule is only guaranteed to work for a stand-alone project if all
of the project’s negative cash flows precede its positive cash flows.
Otherwise, there will be several complications:
1 The IRR may exceed the cost of capital even for a project will a
negative NPV.
2 There may be multiple IRRs
3 There may be no IRR
Since the IRR is not a measure of value, it is easy to manipulate it by
restructuring the project’s cash flows.
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 Internal rate of return rule

Conflicts between the NPV rule and the IRR rule

1 For conventional stand-alone projects, the NPV and IRR rule

will usually be in agreement.

2 In ranking several projects, sometimes the NPV and IRR rules

may give different ranks.

3 In case of such conflicts, the NPV rule is to be given

preference since the IRR ignores the scale of the project.

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 Internal rate of return rule

Example of NPV and IRR criteria

NPV vs IRR example

Question: Find out the NPV and IRR for each of the two projects shown below.
Which is the preferred project?
If the hurdle rate is 10%, what would you decide on the basis of IRR?

Expected after-tax net cash flows (|)

Year Project 1 Project 2
0 -1000 -1000
1 500 100
2 400 300
3 300 400
4 100 600
Total inflows 1300 1400

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 Internal rate of return rule

Example of NPV and IRR criteria

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 Internal rate of return rule

NPV profile

1 The NPV profile is a graph of the project’s NPV over a range

of discount rate values.

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 Internal rate of return rule

Example of NPV profile

NPV profile example

Question:Using costs of capital varying from 0% to 20%, draw the NPV profile of both
projects shown below and determine the crossover rate.
Which project’s NPV is more sensitive to changes in the cost of capital?

Expected after-tax net cash flows (|)

Year Project 1 Project 2
0 -1000 -1000
1 500 100
2 400 300
3 300 400
4 100 600
Total inflows 1300 1400

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 Internal rate of return rule

Example of NPV profile

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 Internal rate of return rule

Role of cash flow pattern

Role of cash flow pattern

Question: Find the NPV (at 10% cost of capital) and IRR for projects L and B shown
below.
Using cost of capital values of 0%, 10%, 20%, 30%, 40% and 50% etc., draw their NPV
profiles.

Expected after-tax net cash flows (|)

Project Year 0 End of Year 1
L -1,00,000 1,20,000
B 83,333 -1,00,000

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 Internal rate of return rule

Role of cash flow pattern

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 Internal rate of return rule

Role of cash flow pattern

Role of cash flow pattern

Question: Find the NPV (at 10% cost of capital) and IRR for the project shown below.
Using cost of capital values of 0%, 20%, 40%, 60%, 80% and 100% and 120%, draw its
NPV profile.

Expected after-tax net cash flows (|)

Year 0 1 2
Cash Flow (|) 1.0 -2.0 1.5

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 Internal rate of return rule

Role of cash flow pattern

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 Internal rate of return rule

Role of cash flow pattern

Role of cash flow pattern

Question: Find the NPV and IRR for the following strip mine development project.
The large negative cash flows at the end of the project are needed to restore the land
back to its original condition.
Also find NPV if project’s cost of capital is 10%.

Expected after-tax net cash flows (|)

Year 0 End of year 1 End of year 2
Cash Flow (|) -1.6 10 -10

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 Internal rate of return rule

Role of cash flow pattern

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 Internal rate of return rule

Comparing returns from different projects

It is meaningful to compare IRRs of different projects only if they

are similar in scale of investment, the timing of their cash flows and
their riskiness.

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 Internal rate of return rule

Modified Internal Rate of Return

IRR assumes that project cash inflows are re-invested at the project
IRR itself, which is an unrealistic assumption
MIRR assumes, more realistically, that the cash inflows are re-invested
at project’s cost of capital.

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 Internal rate of return rule

Modified Internal Rate of Return

N
X Cash outflow t
PVoutflows =
t=0
(1 + r )t

N
X
TVinflows = Cash inflow t (1 + r )N−t
t=0

TVinflows
PVoutflows =
(1 + MIRR)N

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 Internal rate of return rule

Modified internal rate of return

MIRR calculation example

Question: Assuming a cost of capital of 10%, find the Modified

Internal Rate of Return (MIRR) for projects 1,2 and the strip mine
project above.

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 Internal rate of return rule

Example of Modified internal rate of return

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 Internal rate of return rule

Example of Modified internal rate of return

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 Profitability index/Benefits-costs ratio rule

Table of Contents

1 Accounting rate of return rule

2 Payback period rule

3 Discounted payback period rule

4 Net present value rule

5 Internal rate of return rule

6 Profitability index/Benefits-costs ratio rule

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 Profitability index/Benefits-costs ratio rule

Profitability index/Benefits-costs ratio rule

1 Accept the project or investment if its P>1.

2 Choose a project which has a greater PI over others with

smaller PIs.

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 Profitability index/Benefits-costs ratio rule

Profitability Index computation

1 The profitability index is defined as the ratio of the PV of cash inflows
and the PV of cash outflows associated with the project or
investment.

2 It gives an indication of the gains from the project per Rupee of costs
incurred.

PV of benefits
PI =
PV of costs
Pn Cin,t
t=0 (1+r )t
= Pn Cout,t
t=0 (1+r )t

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 Profitability index/Benefits-costs ratio rule

Example of Profitability Index criterion

Profitability index example

Question: Find out the profitability index for each of the two projects shown below.
Assume the opportunity cost of capital for both to be 10%.
Which is the preferred project?

Expected after-tax net cash flows (|)

Year Project 1 Project 2
0 -1000 -1000
1 500 100
2 400 300
3 300 400
4 100 600
Total inflows 1300 1400

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 Profitability index/Benefits-costs ratio rule

Example of Profitability Index criterion

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 Profitability index/Benefits-costs ratio rule

Merits and demerits of profitability index criterion

1 Merits
1 Based on cash flows
2 Takes into account the time value of money
3 Enables ranking of projects based on per unit benefit
2 Demerits
1 A project that is ranked higher than another in terms of PI may have a
much smaller scale and therefore may contribute much less to value in
absolute terms as compared to the other

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 Profitability index/Benefits-costs ratio rule

Internal Rate of Return

Syntax: = IRR(values, [guess])

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 Profitability index/Benefits-costs ratio rule

Internal Rate of Return

The sequence of values must have both positive and negative terms
Guess is a number for starting the iteration. Defaults to 0.1 i.e., 10
percent

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 Profitability index/Benefits-costs ratio rule

Interest rate for a loan or investment

Syntax: = rate( nper, pmt, pv, [fv], [type], [guess])

rate The discount rate
nper The number of periods
pmt The amount of the payment outflow per period; should be
with a minus sign
pv The present value of the payments stream; should be with a
minus sign
fv (optional; defaults to zero) The future value of the payments
stream; should be with a minus sign
type (optional; defaults to 0) 1 if payments go out at the start of
each period and zero if they go out at the end
guess is a number for starting iterations. Defaults to 0.1

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 Profitability index/Benefits-costs ratio rule

Modified Internal Rate of Return

Syntax: = MIRR(values, finance rate, reinvest rate)

values The stream of cash flows; must have at least one positive
and one negative value
finance rate The cost of borrowing
reinvest rate The rate at which the cash flows are reinvested

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 Profitability index/Benefits-costs ratio rule

Internal Rate of Return for a schedule of cash flows

Syntax: = XIRR(values, [dates], [guess])

values The stream of cash flows; must have at least one positive
and one negative value
dates The schedule of dates; should be in date - format; For
example, use DATE(2016,6,30) for the 30th day of June,
2016
guess is a number for starting the iteration. Defaults to 0.1 i.e., 10
percent

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