UNIT- 4

PROJECT INVESTMENT APPRAISAL CRITERIA

Introduction
 There are several criteria that have been suggested by
economists, accountants, and others to judge the
worthwhileness of capital projects.
 The important investment criteria, classified into two broad
categories:
 Non-discounting criteria or traditional techniques:
 Payback period
 Accounting rate of return (ARR)
 Discounting criteria or time adjusted techniques:
 Net present value (NPV)
 Benefit cost ratio or profitability index method (BCR)
 Internal rate of return (IRR)
 Non-discounting criteria or traditional techniques:
Payback period:
 The payback period is the length of time required
to recover the initial cash outlay on the project.
 Decision rule:
 Accept the project if the actual or computed
payback period is less than the maximum PB
period set by the firm, otherwise the project is
rejected.
 In ranking two projects, the project with shorter
payback period should be chosen because it pays
for itself more quickly.
 A. Payback period with equal cash inflows:
 When the project generates constant annual cash inflows, the
following one is the formula to calculate payback period.
 PBP = Net investment/Annual cash inflows
 For example, the information provided below pertains to
project “A” of XYZ corporation. The maximum payback period
set by the firm’s management is 4 years.
Net investment = $12,000
Annual cash inflows = $4000
Estimated life = 5years
 Required:- Compute the payback period and give your decision.
 The PBP = $12,000/$4,000 = 3 years
 Decision: XYZ corporation should accept project ‘A’ because the
computed PBP (3 years) is less than the maximum allowable
PBP (4 years).
Payback-1 = 2 + $30/$80 years
= 2.4 years.
Payback-2 = 1.33 years.

Expected Net Cash Flow

Year Project 1 Project 2
0 ($100) ($100)
1 10 90
2 60 30
3 80 50
 B:Payback period with unequal cash inflows:
 If the expected cash inflows are unequal, the PBP
is calculated by determining the length of requires
for cumulative cash inflows to equal the net
investment.
 PBP = Year before recovery + Unrecovered cost at
start of year/Cash flow during the next year.
 Case-1: Determine the pay-back period for a
project which requires a cash outlay of $10,000
and generates cash inflows of $2,000, $4,000,
$3,000 and $2,000 in the first, second, third and
fourth year respectively.
Payback
Payback period = Expected number of years required to recover a project’s cost.

Expected Net Cash Flow

Year Project L Project S
0 ($100) ($100)
1 10 90
2 60 30
3 80 50
 Case-2: There are two projects ‘x’ and ‘y’. Each
projects requires an investment of $56,000. You
are required to rank these projects according to
the pay-back period method form the following
information.
Cash inflows
Year Project ‘X’ Project ‘Y’
1 $14,000 $22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000
 Limitations of payback period method:
 Though payback period method is the simplest,
oldest and most frequently used method, it
suffers from the following limitations.
 It does not take into account the cash inflows
earned after the payback period and hence the
true profitability of the projects cannot be
correctly assessed.
 For example, there are two projects ‘x’ and ‘y’. Each
project requires an investment of $25,000. The cash
inflows from the two projects are as follows:
Year Project ‘X’ Project ‘Y’

1 $5,000 $4,000
2 8,000 6,000
3 12,000 8,000
4 3,000 7,000
5 - 6,000
6 - 4,000

 According to the payback method, project ‘x’ is better

because of earlier payback period of 3 years as compared
to 4 years payback period in case of project ‘y’.
 But it ignores the earnings after the payback
period.
 Project ‘x’ gives only $3,000 of earnings after the
payback period while project ‘y’ gives more
earnings i.e. $10,000 after the payback period.
 It may not be appropriate to ignore earnings after
the payback period especially when these are
substantial.
 It is a measure of the project’s capital recovery,
not profitability.
 Another limitation of this method is that it ignores
the time value of money and does not consider
the magnitude and timing of cash inflows.
 It treats all cash flows as equal though they occur
in different periods.
 It ignores the fact that cash received today is
more important than the same amount of cash
received after some years.
 For example:
Year Annual cash inflows
Project-1 Project-2
1 $10,000 $4,000
2 8,000 6,000
3 7,000 7,000
4 6,000 8,000
5 4,000 10,000
Total $35,000 $35,000

 According to the payback method both the projects may be treated

equal as both have the same cash inflows in 5 years.
 But in reality project no.1 gives more rapid returns in the initial
years and is better than project no.2.
 C. Discounted payback period:
 As we discussed above the serious limitation of the payback
period method is that it ignores the time value of money.
 Hence, an improvement over this method can be made by
employing the discounted payback period method.
 Under this method, the present values of all cash outflows
and inflows are computed at an appropriate discount rate,
 The present values of all inflows are cumulated in order of
time.
 The time period at which the cumulated present values of
cash inflows equals the present value of cash outflows is
known as discounted payback period.
 The project which gives a shorter discounted payback
period is accepted.
Discounted pay back
Year Project L Project S

Cash flow Discounted cash Cash flow Discounted cash

flow flow
0 ($100) ($100) ($100) ($100)
1 10 9.09 90 81.82
2 60 49.59 30 24.79
3 80 60.12 50 66.55

Given a 10% weighted average cost of capital, the

payback period will be:
Discounted pay-back – project L = 2 + (41.32/60.12) = 2.7
years
Discounted pay-back – project S = 1 + (18.18/24.79) =
1.7 years
 Case-3: The following information regarding to project ‘A’ and ‘B’ of XYZ
corporation.
Cost of the projects = $56,000
Life of the projects = 5 years
Cost of capital (cut off rate) = 10%
Annual cash inflows of projects are as follows:
Cash inflows
Year Project ‘A’ Project ‘B’
1 $14,000 $22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000
Total $93,000 $93,000

 Required:- Compute discounted payback period and give your decision?

Accounting rate of return
 This method takes into account the earnings expected
from the investment over their whole life.
 It is called as ARR method for the reason that under
this method, the accounting concept of profit (net
profit after tax and depreciation) is used rather than
cash inflows.
 Decision rule:
 Accept the project if the computed ARR is greater than
the maximum target ARR set by the firm, otherwise the
project is rejected.
 In ranking projects having the same target ARR, the
project with the highest ARR should be selected
because it is more profitable.
Total profits (after dep. & taxes)
 Therefore, ARR = × 100
Net investment × No. of years of profits

(or)

Average annual profits

ARR = × 100
Net investment

Average investment = investment + salvage value /2

ARR = Average annual profit after dep & taxes /
Average Investment ) X 100
 Case-4: A project requires an investment of
$500,000 and has a scrap value of $20,000 after
five years. It is expected to yield profits after
depreciation and taxes during the five years
amounting to $40,000, $60,000, $70,000, $50,000
and $20,000. Assume maximum target ARR set by
the firm is 9%.
 Required:- Calculate ARR on the investment and
give your decision.
ARR =??
• Net investment =500,000-20,000 = 480,000
• Total Profit after dep and tax = 240,000
• 480,000 / (240,000 x 5 years) =
• 480,000/ (1,200,000) =0.04 =4%
• Thus , since the computed ARR is smaller than
the targeted ARR = 9% ,it should be rejected.
 Discounting criteria or time adjusted techniques:
 The traditional methods of project investment appraisal i.e.,
payback method as well as ARR method, suffer from the
serious limitations that give equal weight to present and future
flow of incomes.
 These methods do not take into consideration the time value of
money, the fact that a Birr earned today has more value than a
Birr earned after five years.
 The time adjusted or discounted criteria methods take into
account the profitability and also the time value of money.
 Net present value
 The NPV method is a modern method of evaluating investment
project proposals.
 This method takes into consideration the time value of money
and attempts to calculate the return on investments by
introducing the factor of time element.
 It recognizes the fact that a Birr earned today is worth more
than the same Birr earned tomorrow.
 The net present values of all inflows and outflows of cash
occurring during the entire life of the project is determined
separately for each year by discounting these flows by the
firm’s
The netcost
presentof capital
value of projector
is theadifference
pre-determined
between the presentrate.
value of net cash inflows
and present value of initial investment.
n CFt
NPV  
t  0 (1  k) t

 Therefore, symbolically, NPV = Pv – initial investment

 Decision Rule:
Accept if NPV > 0
Reject if NPV < 0
if NPV = 0 (Indifference) may accept
Case 7
So which one is accepted?
• NPVL = $ 18.79
• NPV-S = $73.16
• ‘S’ & ‘L’ both are accepted bcuz both are
greater than 0
 Benefit cost ratio or profitability index method
 BCR is the relationship between present value of cash
inflows and the present value of cash outflows.
 BCR is a slight modification of the NPV method.
 The NPV method has one major drawback that is not easy
to rank projects on the basis of this method particularly
when the costs (cash outflows) of the projects differ
significantly.
 To evaluate such projects BCR is most suitable.
 BCR = PV of cash inflows/PV of cash outflows
Decision Rule:
Accept if BCR > 1
Reject if BCR < 1
if BCR = 1 (Indifference) may accept
 Case-8: Case-8: Refer to the above case (Case-7)
and calculate benefit cost ratio and also give your
decision.
Internal rate of return
 In the NPV method the net present value is determined by
discounting the future cash flows of a project at a
predetermined or specified rate called the cut-off rate.
 But under the IRR method, the cash flows of a project are
discounted at a suitable rate by hit and trial method, which
equates the net present value so calculated the amount of
the investment.
 Under this method, since the discount rate is determined
internally, this method is called as the IRR method.
 Symbolically,
 Decision Criterion:
 If IRR is greater than the cost of capital, accept the project.
 If IRR is less than the cost of capital, reject the project.
 Case-9: Consider the cash flows of project being
considered by ABC Company. Assume that cost of
capital is 13%.
Year Cash flow ($)
0 -100,000
1 30,000
2 30,000
3 40,000
4 45,000
 Required:- Calculate internal rate of return.