SELECTION CRITERIA FOR INVESTMENT PROJECTSThe following criteria are tools to evaluate the cash flows from projects in order for firms to decide if they want to undertake a project or not.I.Average Accounting Return:AAR = (Average net Income/Average Book Value)AAR¿∑t=1N1NetIncometN1∑t=1N2BookValuetN2NI= SALES-COGS-DEP-TAXNote: N1 may not equal N2 because the life of the project could be different from the depreciable 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: 900,000Time0 12345 NI 120,00080,000100,000125,000130,000BV 900,000 600,000300,0000So in this case N1=5 and N2=4 (0 to 3, so 4 years total). Note that N2 equals 4 because we 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 Period The 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, recall from 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 year to get the 100 and this means it will take a total of 2.285 years to pay the initial cost.