FAU FIN 3403 NPV and IRR Alone - SELECTION CRITERIA FOR INVESTMENT PROJECTS The following criteria are tools to evaluate the cash flows from projects in

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

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SELECTION CRITERIA FOR INVESTMENT PROJECTS The 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 = 1 N 1 NetIncome t N 1 t = 1 N 2 BookValue t N 2 NI= SALES-COGS-DEP-TAX Note: 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 project If AAR < Firm’s required rate of return on the project => Reject the project Example: 5yr project, but 3yr depreciable life, (straight line depreciation), cost of the project: 900,000 Time 0 1 2 3 4 5 NI 120,000 80,000 100,000 125,000 130,000 BV 900,000 600,000 300,000 0 So 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 = 120 K + 80 K + 100 K + 125 K + 130 K 5 900 K + 600 K + 300 K 4 = 555 / 5 1800 / 4 = 24.6 If AAR > Firm’s required rate =>ACCEPT Advantages- 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 project If Pay back time > Required time => reject project Pay Back example Cost of project is $600 and it generates the following OCFs, recall from chapter 2 that OCF is OCF= (Sales-COGS)(1-tr.) + Dep.*tr 1 2 3 4 OCF 200 300 350 400 Solve for the number of years by finding how many years it takes to pay back the $600 (200 + 300 + 100 – 600)= 0 So 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.

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