# FAU FIN 3403 NPV and IRR Alone - SELECTION CRITERIA FOR...

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• AjaniG
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SELECTION CRITERIA FOR INVESTMENT PROJECTSThe following criteria are tools to evaluate the cash flows from projects in order forfirms to decide if they want to undertake a project or not.I.Average Accounting Return:AAR = (Average net Income/Average Book Value)AAR¿t=1N1NetIncometN1t=1N2BookValuetN2NI= SALES-COGS-DEP-TAXNote:N1 may not equal N2 because the life of the project could be different from thedepreciable life.RULE: If AAR > Firm’s required rate of return on the project => Accept the projectIf AAR < Firm’s required rate of return on the project => Reject the projectExample:5yr project, but 3yr depreciable life, (straight line depreciation), cost of the project:900,000Time012345NI120,00080,000100,000125,000130,000BV900,000600,000300,0000So in this case N1=5 and N2=4 (0 to 3, so 4 years total).Note that N2 equals 4 becausewe have depreciation occurring over all 4 periods, from 0, 1, 2, and 3.Then,AAR =120K+80K+100K+125K+130K5900K+600K+300K4=555/51800/4=24.6If AAR > Firm’s required rate =>ACCEPTAdvantages- easy to calculate, information easy to get.1
Disadvantages- Time value of money ignored, uses accounting figures not cash flows,benchmark rate is arbitrary.II.Pay Back PeriodThe number of years it takes to pay back the initial investment.RULE:If Pay back time < Required time => accept projectIf Pay back time > Required time => reject projectPay Back example Cost of project is \$600 and it generates the following OCFs, recallfrom chapter 2 that OCF isOCF= (Sales-COGS)(1-tr.) + Dep.*tr1234OCF200300350400Solve for the number of years by finding how many years it takes to pay back the \$600(200 + 300 + 100 – 600)= 0So we need to get \$100 more after year2.Thus it will take (100/350) =.285 of the third