The potentialchoicesfor valuation criteria in making an investment decision are numerous.They range from the simple, forexampleReturnonInvestmentandPayback,tothemorecomplicated,suchasInternalRateofReturn(IRR)andNet PresentValue(NPV).Mostcompaniesusemultiplemeasureswhenevaluatingwhetherornottomakeaninvestment. Thequestionoftenarises“WhichmeasureshouldIchoosewhenonecriterionindicatestheinvestmentisagoodone and another criterion indicates it is a bad one?”This How To will help answer that question.
Valuation Criteria Choices
The following valuation criteria will be described including example calculations:
•Return on Investment (ROI)
•Payback
•Internal Rate of Return (IRR)
•Net Present Value (NPV)
Return on Investment (ROI)
ReturnonInvestment,orROI,isthetotalreturnfromtheinvestmentdividedbythetotalcostoftheinvestment.The decisionruleistoacceptallprojectswheretheROIisgreaterthanthefirm’sopportunitycostofcapital(seeAppendix for the definition ofCost of Capital).
In this example, two dollars are returned for every dollar invested.The ROI is 200%.
TheadvantageorROIisthatitissimpletocalculate.ThemajorflawofROIisthatitignoresthetimevalueofmoney (see Appendix for a description oftime valueof money).
Thepaybackperiodforaprojectisthenumberofmonthsoryearsittakestorecovertheinitialcashoutlayonthe project.The decision rule is to accept all projects where payback is less than a certain time period; e.g.one year.
LikeROI,paybackhastheadvantagethatitissimpletocalculate.Paybackisoftenusedasacrudeproxyforrisk;the longerthepaybacktheriskiertheproject.Thereare, however,muchbetter methodsfor measuringtheriskofaproject such as Scenario and Monte Carlo risk analysis (see Appendixfor a description ofMonteCarlo risk analysis).
The majorflawofthepaybackcalculationisthatallreturnsafterthepaybackperiodareignored.Inthe exampleabove, the 100,000return in year 2isignored.
Internal Rate of Return (IRR)
TheinternalRateofReturn,orIRR,isthatdiscountratewhichequatesthepresentvalueofcashinflowswithinitial investment.The decision rule is to accept all projects where IRR is greater than the firm’s opportunitycost ofcapital.
ThecashflowsinExample3arethesameasExamples1and2.TheIRRmeasuresthecompoundrateofreturnofthe project over time.Note the IRR of 84% is much less than the simple ROI of 200% due tothe effect of compounding.
The advantage of IRR is that it incorporates the time value of money.The flaws of IRR are:
1.TheIRRcalculationassumesthatallintermediatecashflowsarereinvestedattheIRRrate.Amorerealistic assumptionisthatallintermediatecashflowswillbe reinvestedinprojectsthat earnthefirm’s opportunitycost ofcapital.
2.Whencashflowschangedirection,oralgebraicsign,severaltimesduringtheproject,therearemultipleIRRs associated with the project.This condition is shown in the example below:
There are two IRR solutions to this example: 25% and 400% (seeAppendixfor an explanation why this is the case).Since both are greater than the firm’s 10% cost of capital the project would be accepted even though the NPV is negative703.
3.Adesirablepropertyofcapitalbudgetingrulesdemandsthatmanagersbeabletoconsidereachproject independentlyofallothers.ThisisknownastheValueAdditivityprinciple.Itimpliesthatthevalueofthefirm isequaltothesumofthevaluesofeachofitsprojects.Thatis,thefirmmaybeconsideredasaportfolioof projects.Theproblem with IRR is that thesum of individual projectIRRs is not equal to the IRR of thesum of the projects,as shown in the example below:
In this example, the sum of the project IRRs is much greater than the true IRR of the two projects added together.
The Net Present Value, or NPV, is calculated by discounting the net cash flows at the firm’s opportunity cost of capital. The decision rule is to accept all projects where NPV is greater than zero.
With NPV, unlike IRR, the sum of the project NPVs is the same as the NPV of the two projects added together.
The advantages and disadvantages of each valuation criterion are:
Whencriterionconflict,itishighlyrecommendedthatthefinaldecisionbebasedonNPV.TheNPVoftheprojectis exactly the same as the dollar increasein shareholders’ wealth.
AsUCLAfinanceprofessorTom Copeland writes(1):
“The NPV criterion is the only on which is necessarily consistent with maximizing shareholders’ wealth.”
ForamorecompleteaccountofwhyNPVisbest,thereaderisalsodirectedtoRichardBrealeyandStewartMyers, Chapter 5 “Why net present value leads to better investment decision than other criteria”(2)
(1) Copeland, Thomas; Weston, Fred, Financial Theory and Corporate Policy, , Addison Wesley, 1980, page 28
(2) Brealey, Richard; Myers, Stewart, Principles of Corporate Finance, McGraw Hill, 1981