Term Paper

On

Investment Criteria
Course: Project Management

Course Code: MBA-502

Submitted to:
Rabaya Bosri
Lecturer,
School of Business
University of Information Technology & Science.

Submitted by:

SL ID Name Remarks
1. 1814202021 MD.Zahedul Islam Shakil
2. 1814202011 Uzzol Ahmed
3. 1814202012 Rakib Dewan
4. 1814202013 Md. Saddam Hossain
5. 1814202016 Tuhin Sardar

Submission Date: 03/05/2018

1
03rd May 2018
Rabaya Bosri
Lecturer,
Department of Business Administration

University of Information Technology & Sciences.

Submission of a term paper on: “Investment Criteria”

Dear Madam,

This is our pleasure to accomplish the term paper of Project Management (MBA-502) and
submit the term paper on “Investment Criteria”. We have prepared the report on the basis
of the Study in Project Management.

This report is prepared on the basis of secondary data. Secondary data was collected from
various printed documents like journal, newspapers etc. would like to express our gratitude to
you for your tiresome effort for us which provided the opportunity to complete this project.

Thank you

For your kind consideration.

Yours Sincerely,
On behalf of the group,
Md.Zahedul Islam Shakil

ID: 1814202021

2
 Acknowledgement

In preparing this term paper, we got full co-operation from our class mates. That was a great advantage
for us. We would like to thank all the members of our group who helped us sincerely from every
respect. An individual can achieve no noble achievement. We are indebted to a number of persons
for their kind recommendation, direction, co-operation and their collaboration. First of all, we would
like to thank our honorable course teacher Rabaya Bosri Lecturer, who was always ready to help us by
giving necessary advices & support for the preparation of this term paper. This term paper suffers from
many shortcomings; nevertheless, we have exerted our best efforts in preparing this term paper. We
seek excuse for the errors that might have occurred in spite of our best effort.

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 Executive Summary
If the goal of management is to create value for the shareholders, it is necessary make decisions that are
based on an of measurement of value. There are numerous such measures for capital projects. They
are broadly divided into “accounting” measures, such as return on investment, and discounted cash
flow measures, such as net present value. The difference between the two is that the discounted cash
flow measures account for the time value of money, whereas the other do not. The payback period and
the return on investment are two of the accounting measures. These have the advantage that they are
easy to calculate and intuitively easy to interpret. However, for major capital projects that are expected
to last a number of years, discounted cash flow techniques are preferred. The two most popular of the
discounted cash flow techniques are the net present value and the internal rate of return. Other
techniques that are discussed is, the benefit-cost ratio. The net present value and the internal rate of
return do not always make the same recommendation for a project. The reasons for this disagreement
are considered.

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Contents
1 Introduction .................................................................................................................................... 6
2 Origin of the Paper .......................................................................................................................... 7
3 Objectives of the study ................................................................................................................... 7
4 Scope ............................................................................................................................................... 7
5 Methodology................................................................................................................................... 7
6 Sources of Data Collection .............................................................................................................. 7
7 Evaluation criteria ........................................................................................................................... 8
7.1 Discounted cash flow (DCF) criteria ........................................................................................ 8
7.1.1 Net Present Value - NPV............................................................................................... 9
7.1.2 Benefit-Cost Ratio ......................................................................................................... 10
7.1.3 Internal Rate of Return (IRR)...................................................................................... 12
7.2 Non-discounted cash flow criteria ........................................................................................ 14
7.2.1 Payback Period .............................................................................................................. 14
7.2.2 Accounting Rate of Return (ARR) ............................................................................... 15
8 Conclusions ................................................................................................................................... 18
9 References .................................................................................................................................... 19

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1 Introduction
Investment criteria rules may be referred to as capital budgeting techniques, or the investment decision.
A sound appraisal technique should be used to measure the economic worth of an investment project.
The essential property of a sound technique is that it should maximize the shareholders’ wealth. The
following other characteristics should also be possessed by a sound investment evaluation criterion.

• It should consider all cash flows to determine the true profitability of the project.

• It should provide for an objective and unambiguous way of separating good projects form bad
projects.

• It should help ranking of projects according to their true profitability.

• It should recognize the fact that bigger cash flows true profitability.

• It should recognize the fact that bigger cash flows are preferable to smaller once and early cash flows
are preferable to later ones.

• It should help top choose among mutually exclusive projects that project which maximizes the
shareholders’ wealth.

• It should be a criterion which is applicable to any conceivable investment project independent of

other.

These conditions will be clarified as we discuss the features of various investment criteria in the
following pages.

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2 Origin of the Paper

This paper is generated under the academic supervision of Rabaya Bosri Lecturer, School of
Business, University of Information Technology & Science. This report is prepared as the requirement
of “Project Management”. The topic is - “Investment Criteria”

3 Objectives of the study

To have a sound understanding of the investing evaluating criteria.

To get an idea about the different valuation tools.

To gather some practical knowledge regarding valuation.

To identify some problems & suggest some recommendations against those problems.

4 Scope

The study is limited to hypothetical evaluation on the basis of theory and some practical knowledge of
various organization.

5 Methodology

The report is mainly based on secondary data findings. So major parts of the reports represent the
secondary data and analysis. Information about the report has been taken from many journal and
practical reports of the expert.

6 Sources of Data Collection

This report is prepared only by secondary data which includes books, journals, newspaper, research
paper, blogs and many others online based portal.

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7 Evaluation criteria
A number of investments criteria (or capital budgeting techniques) are in use in proactive. They may
be grouped in the following two categories:

7.1 Discounted cash flow (DCF) criteria

• Net present value (NPV)

• Internal rate of return (IIR)

• Profitability index (PI)

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7.1.1 Net Present Value - NPV
Net present value (NPV) is the difference between the present value of cash inflows and the present
value of cash outflows over a period of time. NPV is used in capital budgeting to analyze the
profitability of a projected investment or project.

The following is the formula for calculating NPV:

In this equation:

Ct = net cash inflow during the period t

Co = total initial investment costs

r = discount rate, and

t = number of time periods

A positive net present value indicates that the projected earnings generated by a project or investment
(in present dollars) exceeds the anticipated costs (also in present dollars). Generally, an investment
with a positive NPV will be profitable, and an investment with a negative NPV will result in a net loss.
This concept is the basis for the Net Present Value Rule, which dictates that the only investments that
should be made are those with positive NPV values.

Example of Net Present Value

To provide an example of Net Present Value, consider company Shoes For You's who is determining
whether they should invest in a new project. Shoes for You's will expect to invest $500,000 for the
development of their new product. The company estimates that the first year cash flow will be
$200,000, the second year cash flow will be $300,000, and the third year cash flow to be $200,000.
The expected return of 10% is used as the discount rate.

The following table provides each year's cash flow and the present value of each cash flow.

Year Cash Flow Present Value

0 -$500,000 -$500,000

1 $200,000 $181,818.18

2 $300,000 $247,933.88

3 $200,000 $150,262.96

Net Present Value = $80,015.02

The net present value of this example can be shown in the formula

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When solving for the NPV of the formula, this new project would be estimated to be a valuable venture.

Why it Matters:

NPV is used to analyze an investment decision and give company management a clear way to tell if the
investment will add value to the company. Typically, if an investment has a positive net present value,
it will add value to the company and benefit company shareholders.

Net present value calculations can be used for either acquisitions (as shown in the example above) or
future capital projects. For example, if a company decides to open a new product line, they can use
NPV to find out if the projected future cash inflows cover the future costs of starting and running the
project. If the project has a positive NPV, it adds value to the company and therefore should be
considered.

Use in decision making

If... It means... Then...

NPV the investment would
the project may be accepted
>0 add value to the firm
the investment would
NPV
subtract value from the the project may be rejected
<0
firm
We should be indifferent in the decision whether to accept or reject the
NPV the investment would project. This project adds no monetary value. Decision should be
neither gain nor lose
= 0 based on other criteria, e.g., strategic positioning or other factors not
value for the firm
explicitly included in the calculation.

7.1.2 Benefit-Cost Ratio

A benefit-cost ratio (BCR) is an indicator, used in cost-benefit analysis, that attempts to summarize
the overall value for money of a project or proposal. A BCR is the ratio of the benefits of a project or
proposal, expressed in monetary terms, relative to its costs, also expressed in monetary terms. All
benefits and costs should be expressed in discounted present values. A BCR can be a profitability index
in for-profit contexts. Benefit cost ratio (BCR) takes into account the amount of monetary gain
realized by performing a project versus the amount it costs to execute the project. The higher the BCR
the better the investment. General rule of thumb is that if the benefit is higher than the cost the project
is a good investment.

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Benefit-Cost Ratio or Profitability Index (PI) is a capital budgeting technique to evaluate the
investment projects for their viability or profitability. Discounted cash flow technique is used in
arriving at the profitability index. It is also known as a Profitability Index (PI).

Formula:
PVB
Benefit-cost-ratio (BCR) = 𝐼

Net Benefit-cost-ratio (NBCR) = BCR-1

Calculation:

The BCR is calculated by dividing the total discounted value of the benefits by the total discounted
value of the costs. To calculate the discounted values of each, use the net present value (NPV)
formula, in which the values are divided by the sum of 1 and the discount rate raised to the number of
periods.

For example, assume company ABC wishes to assess the profitability of a project that involves
renovating an apartment building that the company owns, over the next year. The company decides to
lease the equipment needed for the project for $50,000, rather than purchasing the equipment. The
inflation rate is 2%, and the renovations are expected to increase the company's annual profit by
$100,000 for the next three years.

The NPV of the total cost of the lease does not need to be discounted, because the initial cost of $50,000
is paid up front. The NPV of the projected benefits is $288,388, or ($100,000 / (1 + 0.02)^1) +
($100,000 / (1 + 0.02)^2) + ($100,00 / (1 + 0.02)^3). Consequently, the BCR is 5.77, or
$288,388 divided by $50,000.

Interpretation:

If a project has a BCR that is greater than 1, it indicates that the NPV of the project benefits outweigh
the NPV of the costs. Therefore, the project should be considered if the value is significantly greater
than 1. If the BCR is equal to 1, the ratio indicates that the NPV of expected profits equal the costs. If
a project's BCR is less than 1, the project's costs outweigh the benefits and it should not be considered.

In the previous example, company ABC had a BCR of 5.77, which indicates that the project's benefits
significantly outweigh its costs. Moreover, company ABC could expect $5.77 in benefits for each $1
of its cost.

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7.1.3 Internal Rate of Return (IRR)
Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a
project zero. In other words, it is the expected rate of return that will be earned on a project or
investment.

When calculating IRR, expected cash flows for a project or investment are given, and the NPV equals
zero. The initial cash investment for the beginning period will be equal to the present value of the
future cash flows of that investment (cost paid = present value of future cash flows. Hence, the net
present value = 0).

Once the internal rate of return is determined, it is typically compared to a company’s hurdle rate or
cost of capital. If the IRR is greater than or equal to the cost of capital, the company would accept the
project (assuming this is the sole basis for the decision – In reality there are many other quantitative
and qualitative factors that are considered in an investment decision.), and if it’s lower than the
hurdle rate it would be rejected.

IRR Formula

Assume Company XYZ must decide whether to purchase a piece of factory equipment for $300,000.
The equipment would only last three years, but it is expected to generate $150,000 of additional
annual profit during those years. Company XYZ also thinks it can sell the equipment for scrap
afterward for about $10,000. Using IRR, Company XYZ can determine whether the equipment
purchase is a better use of its cash than its other investment options, which should return about 10%.

Here is how the IRR equation looks in this scenario:

0 = -$300,000 + ($150,000)/(1+.2431) + ($150,000)/(1+.2431)2 +

($150,000)/(1+.2431) + $10,000/(1+.2431)4
3

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The investment's IRR is 24.31%, which is the rate that makes the present value of the investment's
cash flows equal to zero. From a purely financial standpoint, Company XYZ should purchase the
equipment since this generates a 24.31% return for the Company --much higher than the 10%
return available from other investments.

Uses Internal Rate of Return

Companies take on various projects to increase their revenue or cut down costs. A great new business
idea may require investing in the development of a new product to achieve this goal.

In capital budgeting, senior leaders would like to know the returns on these investments, and the
internal rate of return is one method that allows them to compare and rank projects based on their
projected yield, and the one with the highest internal rate of return is usually preferred.

Internal Rate of Return is widely used in analyzing investments for private equity and venture capital,
which involves multiple cash investments over the life of the business and a cash flow at the end
through an IPO or sale of the business.

Thorough investment analysis requires an analyst to examine both the net present value (NPV) and
internal rate of return, along with other indicators such as the payback period to select the right
investment. Since it’s possible for a very small investment to have a very high rate of return, investors
and managers will sometimes intentionally pick lower return but higher dollar value opportunities, as
they have more of an impact. Also, it’s important to have a good understanding of your own risk
tolerance, or the company’s investment needs, risk aversion and other available options.

Disadvantages of IRR

Unlike net present value, internal rate of return doesn’t give you the return on initial investment in
terms of real dollars. For example, knowing an IRR of 30% alone doesn’t tell you if it’s 30% of
$10,000 or 30% of $1,000,000.

Using it exclusively can lead you to make poor investment decisions, especially if comparing two
projects with different durations.

Let say a company’s hurdle rate is 12%, and one-year project A has an IRR of 25% whereas five-year
project B has an IRR of 15%. If the decision will be solely based on IRR, it would be an unwise decision
to choose project A over B, just because it has a greater return.

Another very important point about the internal rate of return is that it assumes all positive cash flows
of a project will be reinvested at the same rate as the project, instead of the company’s cost of capital.
Therefore, internal rate of return may not accurately reflect the profitability and cost of a project.

An analyst will alternatively use a modified internal rate of return (MIRR) to arrive at a more
accurate measure.

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7.2 Non-discounted cash flow criteria

• Payback period (PB)

• Accounting rate of return (ARR)

These criteria are briefly summarized in this term paper below.

7.2.1 Payback Period

The payback period is the length of time required to recover the cost of an investment. The payback
period of a given investment or project is an important determinant of whether to undertake the position
or project, as longer payback periods are typically not desirable for investment positions. The payback
period ignores the time value of money (TVM), unlike other methods of capital budgeting such as net
present value (NPV), internal rate of return (IRR), and discounted cash flow.

Payback Period Formula

To find exactly when this occurs, the following formula can be used:

Applying the formula to the example, we take the initial investment at its absolute value. The opening
and closing period cumulative cash flows are $900,000 and $1,200,000, respectively. This is because
as we noted, the initial investment is recouped somewhere between periods 2 and 3. Applying the
formula provides the following:

As such, the payback period for this project is 2.33 years. The decision rule using the payback period
is to minimize the time taken for the return of investment.

Using the Payback Method

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In essence, the payback period is used very similarly to a Breakeven Analysis but instead of the number
of units to cover fixed costs, it considers the amount of time required to return the investment.

Given its nature, the payback period is often used as an initial analysis that can be understood without
much technical knowledge. It is easy to calculate and is often referred to as the “back of the envelope”
calculation. Also, it is a simple measure of risk as it shows how quickly money can be returned from
an investment. However, there are additional considerations that should be taken into account when
performing the capital budgeting process.

Shortcomings
Payback period doesn't take into consideration the time value of money and therefore may not present
the true picture when it comes to evaluating cash flows of a project. This issue is addressed by using
DPP, which uses discounted cash flows. Payback also ignores the cash flows beyond the payback
period. Most major capital expenditures have a long life span and continue to provide cash flows even
after the payback period. Since the payback period focuses on short term profitability, a valuable
project may be overlooked if the payback period is the only consideration.

7.2.2 Accounting Rate of Return (ARR)

Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in
capital budgeting. The ratio does not take into account the concept of time value of money. ARR

calculates the return, generated from net income of the proposed capital investment. The ARR is a

percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents

out of each dollar invested (yearly). If the ARR is equal to or greater than the required rate of return,

the project is acceptable. If it is less than the desired rate,

it should be rejected. When comparing investments, the higher the ARR, the more attractive the

investment. Over one-half of large firms calculate ARR when appraising projects.

Basic formulas

Average return during period

ARR= Average investment

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 Average accounting profit is the arithmetic mean of accounting income expected to be earned during
each year of the project's life time. Average investment may be calculated as the sum of the beginning

and ending book value of the project divided by 2. Another variation of ARR formula uses initial

investment instead of average investment.

Decision Rule

Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In

case of mutually exclusive projects, accept the one with highest ARR.

Examples

An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years.

Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap

value of $10,500 at end of the 6th year. Calculate its accounting rate of return assuming that there are

no other expenses on the project.

Solution

Annual Depreciation = (Initial Investment 𝐼 Scrap Value) ÷ Useful Life in Years

Annual Depreciation = ($130,000 𝐼 $10,500) ÷ 6 𝐼 $19,917

Average Accounting Income = $32,000 𝐼 $19,917 = $12,083

Accounting Rate of Return = $12,083 ÷ $130,000 𝐼 9.3%

Advantages

1. Like payback period, this method of investment appraisal is easy to calculate.

2. It recognizes the profitability factor of investment.

Disadvantages
1. It ignores time value of money. Suppose, if we use ARR to compare two projects having equal

initial investments. The project which has higher annual income in the latter years of its useful life

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 may rank higher than the one having higher annual income in the beginning years, even if the present
value of the income generated by the latter project is higher.

2. It can be calculated in different ways. Thus there is problem of consistency.

3. It uses accounting income rather than cash flow information. Thus it is not suitable for projects

which having high maintenance costs because their viability also depends upon timely cash inflows.

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8 Conclusions

A capital budgeting decision involves planning cash flows for a long-term investment. Several methods
are used to analyze investment proposals: payback, net present value, internal rate of return, and
profitability index. The net present value method, in particular, considers the amount and timing of
cash flows. The analysis is based upon estimates of incremental cash flows after tax that will result
from the investment.

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9 References

1. http://www.investinganswers.com/financial-dictionary/technical-analysis/net-present-
value-npv-2995
2. http://financeformulas.net/Net_Present_Value.html
3. https://www.investopedia.com/terms/n/npv.asp
4. https://en.wikipedia.org/wiki/Net_present_value
5. Kurt, Daniel (2003-11-24). "Net Present Value (NPV) Definition | Investopedia".
Investopedia. Retrieved 2016-05-05.
6. Berk, Johnathan; DeMarzo, Peter; Stangeland, David (2015). Corporate Finance (3rd
Canadian ed.). Toronto: Pearson Canada. p. 64. ISBN 978-0133552683.
7. Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibstein (2010). Marketing Metrics:
The Definitive Guide to Measuring Marketing Performance. Upper Saddle River, New Jersey:
Pearson Education, Inc. ISBN 0-13-705829-2. The Marketing Accountability Standards Board
(MASB) endorses the definitions, purposes, and constructs of classes of measures that
appear in Marketing Metrics as part of its ongoing Common Language: Marketing Activities
and Metrics Project.
8. Marco Raugei, Pere Fullana-i-Palmer and Vasilis Fthenakis (March 2012). "The Energy Return
on Energy Investment (EROI) of Photovoltaics: Methodology and Comparisons with Fossil
Fuel Life Cycles" (PDF). http://www.bnl.gov/. Archived (PDF) from the original on 28 March
2015. External link in |website= (help)
9. Internal Rate of Return: A Cautionary Tale
10. Magni, C.A. (2010) "Average Internal Rate of Return and investment decisions: a new
perspective". The Engineering Economist, 55(2), 150‒181.

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