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Investment decision criteria

Popular capital budgeting investment analysis criteria include net present value (NPV), internal rate of return (IRR), profitability index, payback period, discounted payback period and accounting rate of return.

NPV

Net present value equals the present value of future after-tax net cash flows minus total initial investment outlay. If NPV is greater than zero, a project should be accepted, but if it is less than zero, the project should be rejected.

IRR

The internal rate of return is the discount rate at which the present value of future after-tax net cash flows equals the initial investment outlay. It is the discount rate at which NPV is zero. If IRR is greater than the required rate of return r, a project should be accepted, but if it is less than r, it should be rejected.

Payback period

The payback period is the number of years required to recover the total initial investment. Payback ignores the time value of money, risk of the project and cash flows that occur after the payback period. Even though it is a very imperfect tool for capital budgeting, it may be used to analyze project liquidity.

Discounted payback period

The discounted payback period partially addresses the weaknesses of the payback period. It equals the years it takes the cumulative discounted cash flows from a project to recover the initial investment. Discounted payback period also ignores cash flows occurring after the payback is achieved, which makes it an imperfect measure of profitability and doesn’t factor-in the possibility of negative cash flows occurring after the payback period. Hence, a project can have a negative NPV yet a discounted payback period.

Average accounting rate of return

The average accounting rate of return equals the average net income divided by the average book value of assets. Even though AARR is simple and easy to calculate, it suffers from the following drawbacks: (a) it is based on accounting income and not cash flows, (b) it ignores time value of money, (c) different practitioners use different formulas, and (d) there is no conceptually sound benchmark to compare it to.

Profitability index

The profitability index (also called benefit-cost ratio) is the ratio of the present value of net cash flows divided by the initial investment. It also equals the net present value plus the present value of future cash flows. If PI is greater than 1, NPV is positive and the project is feasible, but if it is lower than 1, NPV is negative, and the project is not feasible. PI measures value earned per dollar of investment and it is particularly useful in capital rationing.

by Obaidullah Jan, ACA, CFA on Wed Feb 26 2020

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