Measures of Investment Worth —Single Project 6.1 INTRODUCTION In this chapter we fous primarily on evaluating indwvidual projects by the application of various numerical criteria, In our anahsis we trea investment projects as almost the same as securities (rocks, bonds, and s0 on). Both invest iment project and securities normally require inital outlays in orgee to previce 4 later sequence of cash receipts. The major difference is that divestment pto- jects are not marketable and securities are, When itis necessary to distinguish berveen projects and securities in ovr discussion, it will be done. Otherwise, the assumption can be made that che analyses are identical “Ten diferent eriteria ace discussed in this chapter. The net present value (PV) exterion i considered the standard measure of investment, and the other sneasures are discussed and compared with it, The PV criterion and its economic ‘mtempretaion by means ofthe proiec balance concept are discussed in Section 62. The internal rae of return IRA) criterion, Solomons average rate oF reuen (ARR) exterion, and mocified internal rate of retuen (MIRE) erterion are de fined in Section 63 and are compared with the PY criterion. In Section 6.4 alternative measures, benefit-cost rauos, a presented, and agin they are com paced with the PV criterion, The payback period ofan invesement is discussed in Section 65. Finally, the time-dependent measure of investment worth is devel ‘oped in Section 66. In discussing the various measures, we need to make cerein assumptions about the investment settings 6.11 Initial Assumptions In the following investment worth analysis, we assume that che MARR (or cost a capital) is known to the decision maker. We also assume a stable, perfect capital market and complete certainty about investment outcomes. In « perfect capital market a firm can raise as much cash as it wants at the going rate of 201202 weasures oF rvvEsTMENT WORTH—SINGLE PROJECT Jnterest, oF the firm has sufficient funds to accept all profitable investments. & perfect capital market makes it possible for a firm to invest as much cash as it ‘wants at the market rate of interest. Since the firm may already have undertaken all profitable investments, the market rate of interest is assumed to measure the return on the firm's marginal investment opportunities. Having complete cer: tainty about an investment means thar the firm has perfect knowledge of the present and future cash flows associated with the project. Because of this know! edge, the firm finds it unnecessary to make any allowarce for uncertainty in project evaluation. ‘These assumptions describe what might be called the ideal investment situation, quite different from the real-world situation, By setting aside certain complications, however, these assumptions will allow us to introduce the topic of investment analysis at a much simpler level than we otherwise could. In later ‘chapters these assumpkions will be removed and the analysis extended to more realistic situations, in which rane of these assumptions is fully satisfied 6.12 Notation To discuss the various evaluation criteria, we will use the following com: ‘mon notation for cash flow representation. FIGURE 6.1. Nott! time, measured in discrete compounding periods F opportunity interest rate (MARR), or market interest rate & b, revenue at end of period 7, 6,, = 0 6, expense at the end vf period », cy, = 0 N project life F,net cash flow at the end of period m (F,, = Oy ~ Cy If by = Gu then F,, = 0, if, <6, then F,, <0) initial investment at time O, a positive amount Assume that the © project) at the enc Figure 6.1 illustrates this notation with a cash flow diagram. Additional nation pertaining to a specific eriterion will be defined later a5 necessary. It must be emphasized that all cash flows represent the cash flows after taxes ‘Then the PY of between 8 ancl ( 6.2 THE NET PRESENT VALUE CRITERION We will use the concept of equivalence to develop the net present value (PV) criterion for evaluating investment worth, The future value and annual equiv alent criteria are variations of the PV criterion found by converting the PV into either the future value or the annual equivalent by using the same interest rate In this section we define and discuss the interpretation of these three criteria, 6.2.1 Mathematical Definition ‘The F,, will be p negative if there based on a rate computed with label the th pe The PY Criterion. Consider a project that will generate cash receipts of, at the tend of each period 72. The present value of cash receipts over the project life, is expressed by PM/ptall profiable investments. A sim (O invest as much cash 5 it irem may already have undertaken nuerest is assumed to measure the ortunities. Having complete cer 1 has perfect knowledge of the he projeet, Because of this know 1 allowance for uncertainty i «tie called the ideal investenent scuation. By seuing aside certain allow Us to introduce the 1opic ua we otherwise could. In later etthe analysis extended to more AHS is Fully satistied 1 we will use dhe following com: ating periods, + oyarket interest rate fe amount Hb, BS 1.6 diggram. Additional notation fo) ee as necessary, It must be coh flows after tases eo 210N velop the net present value (PY) uture value and annual equiv und by converting the PY into oy using the same interest rate ‘pretation of these three ecteria, corerate cash receipts of, at the receipts over the project life, B, 62 THE NET PRESENT VALE CTERION 203, * & t ey a : ie ' i ee 1 He ® % FIGURE 6.1. Notation conventions. (2) Gross cash flow. (b) Net cash flow. Me TF wD Assume that the cash expenses (including the initial outlay associated with the project) at the end of each period are ¢,,. The present value expression of cash expenses, Cis ate ee Me ‘Then the PV of the project (denoted by PV{)] is defined by the difference Detween # and C: that = eva) (63a) rH The F,, will be positive if the corresponding period has a net cash inflow and negative if there is a net cash outflow. The foregoing computation of the PV is, based on a rate of interest that remains constant over time. The PY could be computed with different rates of interest over time, in which case we would label the mt period's rate of interest as 4. The PV expression is then Ay * : b) Min Pot at rate (630)204 essunes oF INVESTMENT WoRT—SINGLE PROJECT For simplicity, we assume here a single rine of interest in computing the PV. We further assume compounding at discrete points in time, A continuous ‘campounding process or continuous cash flows Can be handled according to the procedures outlined in Chapwer 2 ‘A positive PV for a project represents a positive surplus, and we should accept the project if sufficient funds are available for tA project witha negative PV should be rejected, because we could do bererby investing in caber projects at the opportunity rate or outside the market. The decision rule expressed simply 1s re PVG) = 0, cemain indifferent, | HPV) <0, eject. af Future Volue Criterion, Asa variation of the PV criterion, the furure value (FV) criterion measures the economic value of a project at the end of the project's life, W. Converting the project cash flows into a single payment concentrated at period NV peaduces a cash flow equal to FV. ray = D Ba + 9s" = PMA + 9% 4) From another view, if we borrowed and lent at , operated the project, and teh all extra funds to accumulate at , we Would have 2 value equal to FV) at the end cof period N. {fis value is positive, the project is acceptable. If its negative, the project should be rejected. As expected, the decision rule for the FV criterion is the same as that for the PV eritetion, [weve > 0, accep AEFVGD) = 9, remain indieves. IEAM <0, reject Annual Equteatent Criterion. ‘The annual equivalent (AE) criterion is another ‘basis for measuring investment worth that has characteristics similar to those of the PV criterion. This similarity is evident when we consider that any cash flows can be converted into @ series of equal annual payments by firs finding the PV for the original series and then multiplying the PV by the capital recovery factor. wey AB) = P| EES | = PVA (AIP, i.) 65) Because the provide a certeria has Example ‘This exatn: project. eh flo cost ke Ey, Nev ‘The cash th Susainuties Table 6.1 a $1,000 FIGURE 6.2Je rate of interes in computing, the rete points in time. A continuous Boss can be handled according to 2 peositive sumplus, and we should able for i A project with a negative better by Investing in other projects ket The decision role expressed criterion, the forure value (FV) provect at the end of the projects single payment concenteated at (6H) at operated the project, and left sre value equal to AVG) atthe end by acceptable. fit is negative, the decison rule for the FV criterion is uwalent (AP) eritetion is another + huracteristis similar 6 those of ‘we consider that any cash Mow 4 pavments by frst finding the PY PU by the capital recovery factor. PLO AIP, 5, ND 65) (a wey reset uu cmeton 205 Because the factor (A/P, i, N)is positive for ~1 <4 < ce, the AE criterion should provide @ consistent basis for evaluating an investment project a8 the previous, 7 criteria have done. IAB > 0, accept : WAE( = 0, remain inditferent : ARG) < 0, rice Example 6.1 This example will serve 10 illustrate the use of the PV criterion. Consider a project that requires a $1,000 initial investment with the following pateens of ‘cash Flow. Ed of Period _ ash Flow o ee Sana aE Receipt by) #500500 So) SRS Expense) #1000 1004018. aD 260 Net Flow (F,) ~$1.000 400-390 320280240) ‘The cash flow diagram is shown in Figure 62. Assume the firm's MARE is 10%. Substituting £,, values into Eq, 6.3 and varying values (0 = # = 40%), we obv Table 6} and Figure 63. We then find that the project's PV decreases monoto- ca 51.000 FIGURE 6.2, Cash flow diagram for Example 6.4206 NeAsuRes oF nvesTuzT WORT—SNGE PRCT Table 6.1 Net Present Values PV(é) ‘at Varying Interest Rate 4, Example 6.1 ree cece eee ° $6000 25 #95 1 55695 3434 2 51577 ~5730 3 476334 -7515 4 ase 25 92.43 5 42316 10915 6 3675627 125.34 7 3621 8 -HiL03 8 202198 15623 9 ama2 30 17096 10 218431 185.25 n 2134032 ry 1860333 B 1596834 “4 1343135 is 10986 36 -250.60 16 629 v 6558 1B ag 9 9 2045 40 296.48 2 0 800 77 TTTTT TOTTTTTTTTT Dein > SS Inert ate. FIGURE 6.3, Plot of PV(i) a8 2 function of J, Example 6.1 (MARR) Is be the PY (the « Using. sao As00, Since both under these 6.2.2 Throt Anal is through Dbalance ex project ba Project Bale amount ot « over the lite the end of assume th: unless i & computed, Thep, the Up sa the pr This reduce: ain = Lis This amount of period 2 This repr second yea(6. THE NET PRESENT VALLE CRITERION 207° ically with the firm’s f, The project has a positive PV ifthe firm’s interest rate GARR) is below 20% and 4 negative PV if the MARR is above 20%. At t= 10%, the PY (the equivalent present value to the firmn ofthe total surplus) is $241 3 Using Eqs. G4 and 65, we find FV(LO%) = $241.84(E/P, 10%, 5) = $389.49 AE(10%) = $241.84(A/P, 10%, 5) = $58.0 Since both #V(10%) and AE(10%) are positive, the project is considered viable under these criteria, 6.2.2 Economic Interpretation Through Project Balance {An alternative way to interpret the economic significance of these criteria, fs through the project Yalance concept. In this section we define the project balance concept and then explain how these criteria are related to the terminal project balance, Project Balance Concept. ‘The project balance describes the net equivalent amount of dollars tied up in or committed to the project at each point in time lover the life of the project. We will use PB), to denote the project balance at the end of period » computed at the opportunity cost rate (MARR) of f We will assume that the cost of having money tied up in the project is not incurred unless it is committed for the entire period. To show how the PA(H,, are computed, we consider the project described in Example 6.1, (See Figure 6.2.) ‘The project balance at the present time (n = 0) is ust the investment itsell P8(10%), = ~ $1,000 ‘Av = 1, the firm has an accumulated commitment of $1,100, which consists of the initial investment and the associated cost of having the initial investment tied up in the project for one period, However, the project reweas $400 at nm This reduces the firm's investment commitment to $700, so the project balance ain = Lis PB(LO%), = —$1,000(1 + 0.1) + $400 = ~$700 ‘This amount becomes the net amount committed to that project atthe beginning, of period 2. The project balance atthe end of period 2 is, PB(10%), = -$700(1 + 0.1) + $360 = -$410 This represents the cost of having $700 committed at the beginning of the second year along with the receipt of $360 at the end of that year | |208 wessunes oF NWESTMENT WoRTE—sINGLE PROJECT We compute the remaining projet balances similary. PB(I0%), = ~$410(1.1) + $320= - $131.00 PBQO%), = ~$131(1.1) + $280 = $13590 PBCIO%), = $13590(1.1) + $240 = $389.49 Notice thatthe frm fully recovers its inital investment and opportunity cost at the end of petiod 4 and has a profit of $135.90. Assuming that the fern can reinvest this amount atthe same interest rate (i = 10%) in other projects or outside the marker, the project balance grows to $389.49 with the receipt of $240 atthe end of period 5. The project i then terminated with a net profit of $389.49, Irwe compute the present value equivalent of this net profi at time 0, we obtain PV(L0%) = $38949(P/F, 10%, 5) = $241.84 The result is the same as that obtained! when we directly compute the present value of the project at / = 10%. Table 62 summarizes these computational results, Mathematical Derivation. Defining the project balance mathematically based. fon the previous example yields the recursive relationstip PB), = + DPB, + Fy where PBWq = Fy and 2 = 0,1, 2,0... We can develop an alternative expression for the project balance from Eq, 66 by making substitutions as follows, PBOy = Fo PB), = (1+ DF > F PH), = (1 + NC + Fy + Fy) + Fe SRO+O+ROTOFR so that at any period 7 PBOy = FL +A ERLE AP tt, 6D The terminal project balance is then expressed by PB = FL + DN HAL EDN et By = Dnata rm Note that PB(),y is the future value of the project. Table 6.2 + ten Beginning prok PB, Toerest ioned, ding projec eeaeeeeaa Pr ma Economte Inte initial investn PBC, = 0. breaks ever accept a pr terminal pro ‘The facie 1.1 PVA) will be Now the with PYG) > PVand the fu at which the: discussion sa cos at njects oF ce from Eg, 62, THE NET PRESENT VALUE CRITERION 209 Table 6.2 Project Balance Computations for the Project in Example 6.1 4 5 em mo 1 Reginning project balance, PRO Inerest owed, =19 419-131 -+13590 - 1-310 1359 Beet c= HOO EEE OO steL aU. pas aee emo Ending project balnce, #100 #700 =$410 #151 13590 438049 PBOn suite PB 1.000 ~ PRidR) = PADD TOD = SOMA Ie, = PVCLON) = =$1,000 + 400¢1.1)-F + A6oCL.1)=# + 32001.2)-> BOQ) 240(1.1)-9 = $241.86 Economic Interpretation. If PB) > 0, we can say chat the firm recovers the inital invesemen plus any interest owed, with a profit atthe end of the project. If PBC) = Othe firm recovers only the initia investment plus interest owed and breaks even, If P8(i)y < 0, the firm ends up with a loss by not being able to recover even the inital investment and interest owed, Naturally, the firm should accept a project only if PBG)y > 0. The present equivalent amount of this terminal protic is = PBL Oe OFF . Ma, =a (69) ‘The factor 1/(1 + 1 is always positive for —1< {<< «. This implies that the PVE) will be positive if and only if PBy > 9 [14) Now the meaning of the PV criterion should be clear; accepting a project swith PVG) > 0 is equivalent to accepting a project with PBU)y > 0, Because the PV and the furure value are measures of equivalence that difer only in tie times at which they are stated, they should provide identical resul's. The analysis and. discussion should also make clear why we consider PV as the baseline, or230 iescses OF yneSTMENT WoRTH—SINGLE PROJECT correct, criterion 10 use in a stable, perfect capital market with complete certainty. i 6.3 INTERNAL RATE-OF-RETURN CRITERION 6.3.1 Definition of IRR Mathematical Definition. The internal race of retum (IRR) is another time discounted measure of investment wonh similar to the PV criterion. The IRR of a [project is defined as the rate of interest that equates the PV of the entire series Of ‘cash flows to zero. The project’ IRR, i, is defined mathematically by me = 3 tings = 9 10 ‘Multiplying both sides of Fq. 6.10 by (1 + 7), we obtain Zn eye PYG + ye =i) ° a) ‘The lefthand side of Bq 6.11 is hy definition, che future value (terminal project balance) of the project If we multiply both sides of Bq. 6.10 by the capital recovery factor, we obtain the relationship AH") = 0 (see Eq, 69), Alternatively, the IRR of a project may be defined as the rate of imerest that equates the future vaive, terminal projec balance, and annual equivalent value ofthe entire series of cash flows 10 PUG) = FVUP) = PBU)y = AE) = 0 (612) Computational Methods, Note that Eq. 6.11 is a polynomial function of i. A direct solution for such a function is not generally possible except for projects with a life of four periads or fewer, Instead, two approximation techniques are in general use, one using iterative procedures (a teiakand-error approach) and the other using Newton's approximation to the solution of a polynomial, ‘An iterative procedure requires an initial guess. To approximate the /RR, we calculate the PV for a certain interest rate (initial guess). If this PV is not zero, another interest rate is ied. A negative PV usually indicates thatthe choice is 00 high, We continue approximating until we reach the two bounds that contain the answer. We then interpolate to find the closest approximation to the IRA's), ‘The Newton approximation t0 a polynomial f(X) = 0 is made by starting with an arbitrary approximation of X and forming successive approximacions by the formula where {'(X, continue: Example Consider # and 2, resp lex = ‘The deri Suppase The secc The thir Purther sequen. al ae uct(6.10) wanting uons by 63 INTER RATEOR-RETURN CRITERION 217 ax, - £82 1S FEY (613) where /’(Q%,) is the first derivative of the polynomial evaluated at Xj. The process 4% continued until we observe X, = X, Example 6.2 Consider a project with cash flows ~$100, 50, and 84 at the end of periods 0,1, and 2, respectively. The present value expression for this project is Pv) = $100 + + aa Let X = 1/(1 + 1). Our polynomial, the present value function, is then F08) = -100 + Sax + Bax? “The derivative ofthis polynomial is $'0) = 50+ 168x Suppose the firs approximation we make is X, = 08696 (7 = 015) ‘The second approximation is =100 + 50(9.8696) + 84(0.8696» X, = 08696 = 30 + 168(0,8696) = 08339 ‘The thicd approximation is =1o00 + 50(0.8339) + 84(0.8339)? ce 50 + 168(08339) = 08333 Further iterations indicate that X = 0.8333 oF i* = 20%. (With any approx’ ‘we are limited by rounding, so when we get the same answer twice in the Sequence of approximations, we stop. 0. Although the calculations in Newton's method are relatively simple, they are time-consuming if many iterations are requited. The use of a computer is212 meAsuRES oF INVESTMENT WORTHI—SINGLE PROJECT eventually necessary, (When we program the computer, itis wise to set toler ance limits on the degree of accuracy required to avoid unnecessary iterations ) Uniqueness of i, The existence of a unique IRR is of special interest in apply ing the ZRR investment worth criterion. Consider a project with cash flows of =$10, $47, ~$72, ancl $36 at the end of periods 0, 1, 2, and 3, respectively Applying Eq, 6.10 and solving for i gives us three roors: 20%, 50%, and 100%, This realy should not surprise us, since Eq, 6.10 isa third-degree polynomial for the project, Here the plot of PV as a function of interest rate crosses the faxis several times, as illustrated in Figure 64. As we will see in later sections, mult: ple RRs hinder the application of the JRR criterion, and we do not recommend the ZRR criverion in stich cases. In this section we will focus on the problem of ‘whether a unique /RR for a project can be predicted by the cash flow stream. ‘One way to predict an upper limit on the number of positive roots of a polynomial is to apply Descartes’ rule of signs. Descores’ Rule. The numberof real postive roots of an mth-degree polynoninal with real coefficients never greater thas the numberof sign changes én the sequence of the coefficients Letting X = 1/(1 + 4), we can write Eq. 6.10 as Fy t RX + BX2 4 + RyXY =O. (614) ‘Thus, we need examine only the sign changes in F,, (o apply the svle. For ‘example, ifthe project has outflows followed by inflows, there is only one sign change and hence at most one feal pesitive root 1am 20%, 40%, 100%) ra) Interstate, «(6 Multiple internal rates of geen Sor wed Exa the16.14) 63 (RTERYAL FATE-OF-RETURN CRITERION — 273. ‘The Norsttom criterion [5] provides a more discriminating condition for the uniqueness of the root in the interval (0 0 for some values of 7 and PBC"), = O for the remaining values of ‘These’ sign changes in PBC"), indicate thar at some times during the project's life PBC"), < 0) the tiem aets'a8 an “investor” in the project and at other times iPBti*,, > 0] the firm acts as a “borrower” from the project, Classification by bgye An alternative way of distingulshing benveen pure and mixed investments is to compute the Value Of fyq the Smallest interest rate what makes PE(),, <0 for n= 0, 1,2,...,.N~ 1.'Then we evaluate the sign of PBUug)ys the terminal project balance: if PAY) = 0, the project is a pure investment. IF PBUninye < Othe projeat is a mixed investment PBC > 0. We Can find SOME IRR, > fy that will set PBG"y tO zero. Then Use of a higher interest rate will simply magnify the negativity of PB), Thus, the Condition Of # = fy Will ensure the nonposiiy of PAC), for 0% mS ~ 1, This is the definition of a pure investment. TF PBCnyayy © 0, WE CAN ENPECE HAE F< yy Which will Set PBC) (0 fone lmans zero. Becaes (Ptinin) or negative investinent. Figure for the analy ments are al ore wl se mined inves pure investn ple 64 Example We will il numerical Bad of Peo mR Table 638 IRRs. Proje: are pur seen in pe | condition | Table 6: Projet63 INTERNAL RATE-OF-RETURY cxITERION 275 2er0, BECAUSE ipys iS the minimum rate at which the nonpositity condition (PB in) = 0] Sttinfies 0 = m = NV — 1, we know that PBZ"), is aot always zero or negative for 0S m SN ~ 1. This implies that the project is a mixed investment. Figure 6 5 illustrates the final classification scheme that provides the basis for the analysis of investments under the /R& criterion. Note that simple invest ‘ments are always classified as pure investment. (Sce the proof in Bussey [6.)As ‘we will see, the phenomenon of mukiple RRs occurs only in the situation of a mixed investment, Although a simple investment is alvigjs pure invesiment, & pure investment is not necessarily a simple invesiment, as we will seein Exam ple 64 Example 6.4 ‘We will illustrate the distinction between pure and mixed investments with ‘numerical examples. Consider the following four projects with known i values, End of Period =si00 =#100 50 470 50 720 200 360 = 295% P= 20%, 50%, 100% Table 63 summarizes the project balances from these projects at zheit respective IRR, Project Ais the only simple project; the rest are nonsimple, Projects A ancl Care pure investments, whereas projects B and D are mixed investments. As seen in project B, the existence of a unique /RA is a necessary but nota sufficient condition for a pure investment Table 6.3 Project Balances, sample 6.4 ad of Period me et 2 Fy ~100 200 ALA PBC -2Hae ALA 5, 140 =10 32.45% PBL), 755 o FE, 50 50 29.95% PEL), -7995 ~15390 F, 470 20 20% PB(20%) 350 300 50% B{50%) 320 100% PB(100%) 270 180216 wexsunes oF 1wvESTNENT WORT: INGLE PROJECT In distinguishing pure and mixed investments, we could Use the fyn FES. ‘We will show haw this is done for project D. Since N= 3, we need to consider PB), PBL. Ad PBL PRUs = ~190 PB), = PBC) + 4) + 470 = —1004 + 370 PB(i), = PB(),(A + i) — 720 = — 100% + 2704 - 350 Since PB()}y <0, we find the smallest value of 4 that makes both PBC), and PB(t), nonpositive. The minimum value is 370%, NOW we evaluate PBCig,)3 find PHC37O%), = —720(4.70) + 360 = —$3024 < 0 Since PBGgin)3 <0, project D is a mixed investment. 6.3.3 IRR and Pure Investments According to the JRR criterion, a pure investment should be accepted if its ZR is above the MARR (ot cost of capital) to the firm. We will show why this decision rule can produce an accept-reject decision consistent with the PY criterion, Recall that pure investments have the following characteristics 4, Net investment throughout the life ofthe projec. 2. Existence of unique 3. PBC), 50 ford n PVE) \We will first consicir computing PB()y with > #, Here fis the MARR (or cost of capital) tothe firm, Since PBC"), = O for 0 nS. ~ 1 and PBL )y = 0,the effect of a higher compounding rate is to magnify the negativity of these project balances, This implies that PB(D, < PBC" )y = 0. From Eq. 69, this also implies that PVG) < 0.1F/ = F, them PB(f}y = PBC") = 0 so that PVE) = OIF 0 indicating that PV(2) > 0, Hence we accept the investment. This proves the equivalence of the PY and IRR criteria for accept-reject decisions ‘concerning simple investments These relationships are Mlustrated in Figure 6 6 I <0, accept ‘When a firm makes a pure investment, it has funds committed to the project over the life of the project and at no time takes a loan from the project. Only in such a situati eames a poi Exam Con andy we pee ritthe PV D,the: project p implies Wise, This deisions Ure 66, 6.3 INTERNAL RATE-OF RETRO CRITERION Mage > FIGURE 6.6. PV() of simple tnvestment 28 a hunexion o€ 4 situation is a rate of return concept snternal wo the project. Then the IRR can be viewed as the interest rate earned on the committed project balance (unre- covered balance, or negative project balance) of an investment, ro/ the interest ccarned on the initial investment, The reader should keep this in mind, since it is 2 point nck generally understood by many practitioners, Example 65 Consider the project described in Example 6.1, (Note that the project isa simple and pure investment.) The project was acceptable at i = 10% by the PV criterion, We find that the (RR of this project is 20% by solving for * in Eq. 6.10, $400, _$360_ , _ $320 ise tery ae + 8280, $240 Tere Ts pvr) = ~$1,000 + =o Since i > 10%, the project should be acceptable. The economic interpretation of the 20% is that the investment under consideration brings in enouigh cash 10 pay for itself in 5 years and also to provide the firm with a return of 20% on its Invested capital over the project life Expressed another way, suppose that a firm obtains all its capital by bor- rowing from a bank at the interest rate of exactly 20%. tthe firm invests in the project and uses the cash flow generated by the investment to pay olf the principal and interest on the bank foan, the firm should come out exactly even ‘on the transaction, Ifthe firm can borrow the funds ata rate lower than 20% the project should be profitable, Ifthe borrowing interest rate is greater than 20%,218 weistRes OF NAESTMENT WoRTH—SINGLE PROJECT acceptance of the project would result in losses. This break-even characteristic makes the JRR a popular criterion among many practitioners. 6.3.4 IRR and Mixed Investments Recall that the mixed investments have the following characteristics. 1. More than one sign change in cash flow. 2. Possibility of multiple rates of return 3. Mixed signs in PAM), ‘The difficulty in mixed investments is determining which rate 10 use for the acceptance tes, if any. The mixed signs in PBC), indicate that the firm has funds commited to the project part of the time [PA("),, < 0 for some values of ‘n} and takes a “loan from the project the rest ofthe time [PB(¢"),, > 0 for some value of nm), Because of this lending and borrowing activity, there is no rate (of return concept internal to the project. The return on such mixed invest iments tends to vary with the external interest rate (1e., cost of capital) to the firm, To circumvent this conceptual difficulty, we may modify the procedure for ‘computation by compounding positive project balances at the cost of borrowing. capital, and negative project balances atthe cetucn on invested capital (RIC), (We use the symbol r because the return on invested capital of a mixed project is generally not equal to the IRR, #, ofthe project.) Since the firm is never indebt led to the project for pure investment, itis clear that & does not enter into the ‘compounding process; hence this RIC is independent of, the cost of capital 0 the firm. Two approaches may be used in computing 7: the trial-and-error approach and the analytical approach, Trlal-and-Brror Approach, The trialand error approach is similar to finding a projea’s internal rate of return, For a given cost of capital, &, we frst compute the project balances from an investment with a somewhat arbitrarily selected value. Since itis hoped thar projecs will promise a return of at leat the cost of capital, a value of r close to isa good starting point for most problems. For a given pair of (&, 7), we calculate the last project balance and see whether its positive, negative, or zero. Suppose the last project balance PB; By is nee tive—what do we do then? A nonzero terminal project balance indicates that the ‘guessed r value isnot the truer value. We must lower the r value and go through the process again. Converscly, ifthe PBC, Ry > 0, we raise the r value and repeat the process Example 6.6 ‘To illustrate the method described, consider the following cash flow ofa project.cheough value and of s project 63; TERNAL RATE oF RETURN cruTERION 219 Suppose that the cost of capital, &, is known to be 15%. For k = 15%, we must compute r* by trial and error. For & = 15% and trial r = 16%, PBCI6, 15), = ~1,000 ~$1,000 PBL16, 15), = ~1,00001 + 0.16) + 2900 = $1,300. [use r, since PB(AG, 15), < 0} PBLIG, 15), = 13001 + 0.15) ~ 2.080 The terminal project balance is not zero, indicating that * 15 not equal to our 16% «rial r, The next tril value should be smaller than 16% because the terminal balance is negative (~585). After several trials, we conclude that for & = 15%, r* is approximately at 9.13%. To verify the results, PBEOAB, 15), = ~1,000 = -$1,000 PBO.13, 15), = —1,900K1 + 0.0913) + 2.900 = $1,808.70 PBCOA3, 15), = 1,808,701 + 0.15) = 2080= 0 Since * < &, the investment is not profitable. Note that the project woukd also be rejected under the PV analysis at MARR 15%, PVCS%) = ~1,000 + 2,900(P/F, 15%, 1) ~ 2,080(P/F, 15%, 2) = -#510)<0 0 $585 [use & since PBCIG, 15), > 0 7 Analytical Approach. ‘The most direct procedure for determining the functional relationship berween r and k of a mixed investment isto write out the expression for the future value of the project. Since the project balance of a mixed investment |s compounded at either ror &, depending on the sign of the project balance, the terminal (future) balance of he project, denoted by PB(r, #), isa function of two variables. The following steps can be used t0 determine the RIG, r ‘Step 1: Find jg by solving forthe smallest eal rate foe wich all PEUyq)y 0,forn= 1,,...N— 1 This is usually done by tralanbeeror method. Step 2: Find PB Cini 2. If PBUimedw = 0, the project is a pure investment 1) Find the 298, , for which PHC) = 0; investment. (2) Apply the decision rules given in step 5, b.IF PB pial 0, the project is a mixed investment and it is. necessary (0 proceed with step 3 Step 3: Calculate PBVr, #),, according to the following PBC, bp = Fy PAY, b), = PBL, RIL ++ PaKr, RY + #) + F, 1 for a pure if Par #), <0 if PREF By > 0 PBC, Ky = PBKr. Ky A +1) +E, PAL Wy = PoE), YL +R) +E, iE PE B,220 wessines OF poesTMENE WORTH—SINGLE PROEET ‘To determine the positivity or negativity of PBL, tat each pert od, Set 7 = Feige Knowing that 7 fan: (See Problem 6.10.) Step 4: Determine the value of r* by solving the equation PB(r, B)y = 0. ‘Step 5: Apply the following set of decision rules to accept or reject the project. Er > h, accept ler* = &, remain inditerent. ert < he seect | Example 6.7 ‘Comsider the project cash flows given in Example 6.6 [nd of Pesiod o 1 2 cash Flow, | ~$1,000 2900 2,080 There are two sign changes in the ordered sequence of cashflows ( ~). The project has two RRs, cartesponding t0 *, = 30% and i, = 60%. To derive the functional relationship berween the return on invested capital. and the cost of capital & we apply the algorithm described in the preceding section. Step 1 ithe {nin that satisfies the following two equations (N= 2,N — D. PB(i)y = ~1,000 <0 PBC), = ~1,000(1 +) + 2,900 ~1,0001 + 1,900 5 0 Since PB{i}y <4, we need only find the smallest # that satisies PBC), = 0. "The value Of fin 1S 190% Step 2: Calculate PBEpy,)y PBUbpindz = (—1,0005qo, + 190K + fg) ~ 2,080 2080 Since PB)» <0, the project is a mixed investment Step 3: Calculate PE, by, PB(r, By = 1,000 Since PBC, By <0, we wwe r. PBT, Hy 190001 +r) + 2,900 1,000" + 1,900 Step 4: The graph characterist A. Firsts be Th funds capita 2, Seca: inter with i this Thees equal 3. Tio 4. Foure From atau whic The follo definition PUR) inte dis pow accept~re63 INTERNAL RATE. RETURN CRITERION 227 Since r cannot exceed frns PBC #), 2 0. Then we use fe FRCr, By, = (—1,000r + 1,900, + k) = 2,080 Step 4: Find the solution of PB, k), = 0. 2.08 -19- 2% 616) ‘The graph of Eq. 616 is shown in Figure 67. We observe the following characteristics, Fi Se = 208 - 0,7 is » manxonically increasing function 1. First since $5 = GAP E> Or isa manoconically #g function of Je This means that the higher the cost that the firm places on borrowing funds from the project, the higher the return it will require on the invested al 2, Secontl, if we set r = ke in Eq, 6.16, we have r = k =P. Equation 6.16 intersects the 45° line + = d rwice, once atk = 30% and again atk = 60%. With = = #* the terminal project balance PB(r, k), decreases 10 PBC" )p 0. Solving PBL"), = 0 fori yields the IRR of the project. In other words, this mixed investment has multiple rates of return (f," = 30%, 1," = 60%), ‘Therefore, the roots for mixed invesimenc are the values ofthe return on invested capital, r, when the cost of borrowed money, kis assumed to be equal to 3. Third, applying the decision rule, we have 130% <8 < 60X > r* > E accept the project Ihde = 30% oF b= 60% —» 7" =k, remain indecent Ide < 30% ok > 60% +r" < ky ceject the project | 4, Fourth, the decision we make will be consistent with the decision derived the PV criterion when f © MARR = &, The PV of the proieet from apply at an interest rate of k can be expressed as $2,900 _ _$2.080 fas Fite) = ~$1000 + $2900 — “BRO 17) ‘which is also depicted in Figure 6.7, ‘The following comments about the PV function are in order. Fist, the IRR is by definition che solution to the equation PM) = 0. Therefore, we observe that PU(k) intersects the horizontal axis at = 30% and atk = 60%. Second, since PY (&)is positive only in the range 30% 0) and reinvest them each year at, eting them accumulate until time N. What rate of interest does investment C, have to earn to reach the same accumulated value in N periods (15? “Mathematically, we wish to finds to solve the equation cod + sy 2 AG toe" wera arene een ievesment ‘With known s, the acceptance rule is65 (NTERNUL RATEOP RETURN CRITERION 223 We can easily show that the ARR criterion is completely consistent with the PV criterion [2] Recall that for a given project with Fy Dior Us n= 1, the PV acceptance rule is ZT paton>o (6.19) Substituting Cy for Fy (note that Fy = —C,) gives us a< XY nara (6.20) Multiplying both sides of Eq. 6.18 by (2 + )~¥ yields soa ta-v= Desa” 21) By comparing Eqs. 620 and 6.21, we can deduce that CL + SMD > Cy ese >t iy (622) ‘This implies thats > 4, Which isthe ARR acceptance condition, Example 6.8 Consider the eash flows shown in Figure 62, where Cy = 1360, F, = $320,F, 648, we obtain $1,900, F, = $400, F, :280, and F, = $240. Substituting these values into Ea, 1,000(1 + 5) = 400(1.1} + 360(1.1)% + 3201.1) + 280(1.1) + 240 100 Solving for s yields 15%. This tells as that we can invest $1,000 in the project, reinvest the proceeds at our opportunity rate (MARR) of 10%, and have $2,000 at lime 5. If we do not wish 0 invest in the project but still wish to earn $2,000, the original $1,000 would have to earn 15% per period. Since the MARR is 10%, we are clearly beter off accepting the project. Ifs had been less than # = 10%, we would have rejected the project. 0 Modified Internat Rate of Return (MIRR). bs avatiation of the ARK procedure, ‘we may make explicit the expected reinvestment rate of intermediate incomes‘MEASURES OF INVESTMENT WORTH—SINGLE PREBCT Iethe 6 Cash inflam same ash catows Evan ve vue The si crite quit =m + Mire Ecuistnt present ale Sve tr MR p > FIGURE 6.8, Illustration of the MIRR concept and costs and reduce them to an equivalent initial cost and a terminal projet balance, a procedure known as the modified internal rate of return (MIRR) [12] Or the external rate of return, In this way a unique JRR can be computed. This MIRR is defined by Future value of net cash inflow, Present value of net cash outllow D mae, OM +" no Fron we —= (1 + MIRRYY = 5 mine, + 9-" were may 0) = Fy iy > 9, otherwise Fy = 0; minty, 0) = Fy iffy < tahervise f= O; ad i he MARE co the Bim. The meaning oF the ARR i lustraed in Figure 68, By rearranging terms in Eq, 623, we can rewrite as _ S mace, ona +e = [= ¥ mine, ot + 9-* fa + away 62) ws‘al cost and a terminal project sernal rate of retuen (MRR) (12) ‘que IRR cats be computed. This inflow outflow = (1 + MmRRYY (623) = 0, min(F,,, 0 * Fy if Fy, <0, fon, The meaning of the MIRR is atone] any (624) 65 INTERNAL RATE OF RETURN CRITERION 225 If the cash outflow is restricted to she est period, 11 = 0, the MURR is exactly the same as the Ag, s. The acceptance rule is then rae ] me remain inliferent ‘The ARR will always give a unique solution and is also consistent with the PV criterion. The MIRR will always exceed the alternative rate whenever the invest- ‘ment sequence has a positive PY até. This can be visualized from the following equations, ‘The project acceptance condition by the PY criterion is J mace, Nato > =D mins, + a" Present value of e Present value of net cash inflow net cash outflow Multiplying both sides of Eq. 624 by (1 +) yields D mane, n+" =[-3 mine, oc +o Ja + meena + 9 From the relation given in Eq, 6.25, we can say [- 3 mine, + 0-7] a+ awarnca + 9-8 >= DT ming, oO +9-" ‘Simplifying the terms above gives C+ mary > 0 + 9% ‘which indicates that MIRR > i (6.25) (6.26) 627) (628)226 erSURES OF NWESTUENT WORTH—SINGLE PROECT ‘There are three other variations of the MIRR [4], but these indices (includ. Jing ARR and MIRR) have numerical values distinctly different from one another, and without additiona! information provided, these rates are considerably more ‘complex to use than the simple PV criterion. Example 6.9 Using an example from [4], we will ilustrate the method of computing the MIRR, Assume that # = 6% and the cash flow components are Gosh Fly 0 bn fo Se 90 ir) Present value of net cash outflow = +10 + 3(1 + 005)? = $1267 Future value of net cash inflow = 2(1 + 006)? + 23 = $25.25 ng Eq. 6.24, we find 25.25 = 12.671 + MURR)? MIRR = 25.84% nce MIRR > 6%, the project should be acceptable. Note that PV(6%) = $8.53 > 0, 80 the AMRR result is consistent with the PV criterion, 6.4 BENEFIT-COST RATIOS Another way t0 express the worthiness of a project is 16 compare the inflows ‘with the investment. This leads to three types of benefit~cost ratios: the aggre: gate benefit-cost ratio (Eckstein B/C), the netted benefit-cost ratio (simple BIO), and the Lorie—Savage ratio, et B and C be the present values of cash inflows and outflows defined by Eqs. 6.1 and 6.2. We will split the equivalent cost C into two components, the initial capital expenditure and the annual costs accrued in each successive peri cod. Assuming that an initial investment is required during the first m periods, ‘while annual costs accrue in each period following, the components are defined as Yea ton (629) = J gato (630) with:64 wenertt-cosr Ranios 227 (includ: ‘The following example will be used to demonstrate the application of dif another, ferent B/C ratio criteria ash Flow 4, F 10%, we define =5 1 200.1)? + 10(1.2)-3 + 201.1)~4 + 20011)-$ = $41.86 10 + SC.1)-" + 5(L.1)-2 + SCLI)-3 + SCL) + 1001.1) = $32.06 10 + 5(L1)7! = $1455, © = Say? + sCLay“3 + SCLa)~# + 10(1.2)~9 = $1751 PYIO%) = B ~ C= $9.80 6.4.1 Benefit-Cost Ratios Defined Aggregate B/C Ratio, The aggregate B/C ratio introduced by Eckstein (7] is efined as B fre: ite>o (631) oa c the inflows To accept a project, the R, must be greater than 1. Historically, this ratio was the aggre: developed in the 1930s in response to the fact that in public projects the user is generally not che same as the sponsor. To have a better perspective on the user's benefits, we need to separate them from the sponsor's costs. IF we assume that for a project b,, represents the user's benefits and ¢,, the sponsor's costs, the ratio is 4186 Tass + 17s = 15 ‘The ratio exceeds 1, which implies that the user's benefits exceed the sponsor's cous, Public projects usualy also have benefits that are dificult to measure, whereas costs are more easily quantified. In this respec, the Eckstein B/C ratio lends itself readily to sensitivity analysis with respect to the value of benefits. We vill discuss this measure in greater detail in Chapter 14. 630) Netted BIC Ratio. As an alternative expression in defining their terms, some analysts consider only the initial capital expenditure asa cash outlay, and equiv228 wHsuRES OF MvESTIEITT WORTH—SINGLE PROIECT alent benefes become nes benefits (Ie, revenues minus annual outiays). This akernative measure is referred to as the netted benefit—cost ratio, Ry, anc is expressed by (632) The advantage of having the benefit-cost ratio defined in this manner is ca i provides an index indicating the net benefit expected per dollar invesced, somae- times called a profitability Index. Again, for a project to remain under considera: tion, dhe rati9 must be greater than 1. For our example, the Ry i 41.96 ~ 1751 4-2 = 1.674 ‘Note that tbs is just a comparison of the present value of net revenues (F,) with the present value of investment. Since Ry > 1, there is a surplus actlaie 0 and the ‘peuject is favorable, The use of this criterion also fad ils origin int the evaluation of public projects in the 1930s. Lorle~Sarage Ratio. As a variation on Ry, the lorie Savage (2-5) ratio is de- fined as ere the comparison is between the surplus at cime @ and the investment itself IFthe ratio is greater than 0, the project is favorable. Clearly, the Ry B/C and the BIC ratios will always yield the seme decision for 2 project, since both the zatlos and their cespective curolf points differ by 1.9, For our example, L-S ~ 1.614 — 1 = 0.674 > 0, Thus the £-5 ratio alse indicates acceptance of the project. 6.4.2 Equivafence of 8/€ Ratios and PY Using the notation in Section 6.42, we can sate te PV eriterion for project acceptance a5 PDE BHC =B-U+Cy>0. 1634) By transposing the werm (I + G°)1o the righthand side and dling both sides by UC), we have B jeert uro>y13). This Ry, and is (632) 1s thar it 1) with 0 nd the uation be project (634) th sides 64 eanerrr-oost ranos 229° ‘which is exactly the decision rule for accepting a project with the R, criterion. ‘On the ofter hand, by iransposing the term 1 the right-hand side and dividing, both sides of the equation by J, we obtain Bac, . Feri uo swhich is exactly the decision rate for accepting a project with the R,,criterion, In other words, use of Ry or use of Ry will lead to the same conclusion about the initial acceptability ofa single project, as long.as /> Qand / + C" > 0, Notice that these B/C ratios wil always agree wih each ctlrer for an individual project, since Zand C* ace nonnegative Le tc | | PMB + C)>0 BoE oy | Although ARR does not appear 10 be related to the benefit-cost ratios, it does, in fact, yield the same decisions for a project. From Eq. 6.18 we have Catone 3 nae gen Expressed differently, rates to-r= 3 +9" =8-¢ We require 5 > for project acceprance, so we must have Bac230 weisiRes oF INVESIVENT WORTH—SINGLE PROIECT 6.5 PAYBACK PERIOD A popular ruleofthumb method for evaluating projects is 1o determine the umber of periods necded to recover the original investment In this section we present 6w0 procedures for assessing the payback period of an investment 6.5.1 Payback Period Defined Conventional Payback Period. The payback period (PP) is defined as the number of periods it will take to recover the initial investment outlay. Mathe- ‘matically, the payback period is computed as the smallest value of 7 that satisfies the equation 3 ps0 (635) This payback period (n,) i then compared with the maximum acceptable payback period (rtjax) to determine whether the project should be accepted. if Foun > Mey the propased project wil! de accepted. Otherwise, the project will be rejected. Obviously the most serious deficiencies of the payback period ave that i fails co consider the time value of money and that it fails to Consider the conse ‘quences of the investment afier the payback period. Discounted Payback Perlod. As 2 modification of the conventional payback period, one may incorporate the time value of money. The method is to deter- ‘mine the length of time required for the project's equivalent receipts 10 exceed the equivafent capital outlays, Mathematically, the discounted payback period Q is the smallest that satisies the expression e Zrutoneo where i is the MARR 1F we mulkiply bath sides of Bq. 6.37 by (1 + 1), we should obtain e DA + 02-20 (638) Notice that Eq. 6.38 is the definition of project balance PA(A),- Thus, the dis ‘counted payback period is alternatively defined as the smallest re that makesMathe- satisfies (636) preptable pepted. If will be thar it pavback (638) the dis makes 65 parmack penion 237 6.5.2. Popularity of the Payback Period Clearly, the payback period analysis is simple to apply and, in some cases, ay give answers approximately equivalent to those provided! by more sophi cated methods. A number of authors have tried to show an equivalence between the payback period and other criteria, such as 7RR, under special circumstances {11}. For example, Gordon (8) interpreted the payback period as an indirect, though quick, measure of cerurn. With a uniform stream of receipts, the re ‘iprocal of the payback period is the ZR for a project of infinite lite and is a 8004 approximation to this rate for a long-lived project ‘Weingariner (19] analyzed the basic reasons why the payback period mea sure is so popular in business. One reason is that the payback period can function like many other rules of thumb to shortcut the process of generating information and then evaluating it Payback reduces the information search by focusing on the time when the firm expects co “be made whole again.” Hence, it allows the decision maker ‘o judge whether the life of the project past the break: even (bench mark) point is sufficient 40 make the undertaking worthwhile In summary, the payback period gives some measure of the rate at which a project will recover its initial outlay. This piece of information is not available from either the PV or the IRR. The payback period may not be used asa direct Figure of merit, bur it may be used as a constraint: no project may be accepted unless its payback period is shorter than some specified period of time, Example 6.10 Suppose that a firm is considering a project casting $10,000, the life of the project is 5 years, and the expected net annual cash flows at the end of the year are as follows (assume MARR = 10%). Cash Flow tm 1 2 3 i F, “Fio000 $3,000 $3,000 #4000 $3,000 #5,000 CUmulauve F, $10,000 7,000 — 4,000 © 3.000 6000 Pva0%) $0000 27272479 3005209862 ‘Cumulative present value $19.00 -7273 4794 178 260,122 ‘The conventional payback period is 3 years, whereas the discounted payback period is 3.87 years. This example demonstrates how consideration of the time value of money in payback analysis can produce different results. Clearly, this, discounted measure is conceptually better than the conventional one, but both measures fail to indicate the overall profitably of the project. 6.6 TIME-DEPENDENT MEASURE OF INVESTMENT WORTH ‘The project balance, which measures the equivalent loss or profit of an invest ment project as a function of ime, is a recent development thar provides addi tional insight into investment decisions. In Section 6.22 we defined the project232 weasunes OF IESTNENT WORT —SINGLE PROJECT balance and demonsiraied its calculation both mathematically and through € naples. This section presents particular characteristics of project balance pro. {les ane their economic inteepretation. We also discuss some possthle messes of invesiment desirability based on these profiles. (The material prevented in {his section is based on the analysis given by Park and Thuesen (141) 6.6.1 Areas of Negative and Positive Balances Recall that the project balance is defined by PH, © Sn 40", n= 0.42 By plowing PB(0,, 28 2 fonction of time 7, we can trace the time path of project balance as shown in Figure 6.9, This cime path is referred ta as che project dala patsern, a x provides the basic information about the atractiveness of a particular investment proposal a8 a funtion oF ts life. The shade area repre sents the period of time cising which the project balance has wegeive salves, thot is, the time during which the ‘nial investment plus tgerer is not Sly secoucred, ‘This area is referced to 28 the area of tegative balance (ANB) Satherincaly, the avea is eepresented by er ANB = DPR, (6.39) svhere Q Is the discounted payback period {the rst pesiod in which PBC), = 0). Since the value PBA), for n Q represera he magnitude of positive project balance, there is no possible [oss even though the project 5 terminated in a period before the end of ts life or no additional receipts are received. Thus, PACO,, becomes the net equivalent dollars earned. Finally, the Tast projec balance PB(A, represents the net future value of the project (or terminal profit) at the end of its life. The PV of the project.can be found eastly by a simple transformation, shown in Eq. 69. 6.6.2, Investment Flexibility To illustrate the basic concept of investment flexibility and its discriminat ing ability compared with the traditional measures of investment Worth (&2, PV), we consider the hypothetical investment situation shown in Figure 6.104 Projects 1 ancl 2 have single-payment and walfarnyseries cash flows, respec- Lively, Projects 3 and 4 are gradient series, one being an increasing gradiens series and the other a decreasing gradient series. All the projects require the same initial investment and have a service life of 3 years. all the projects would, have an equivalent furure value of $63.40 at a MARR of 10% [or PMLIO%) = $47.63}, This implies dat no project's preferable to the others when they are compared on the basis of present value. Plotting, the project balance partern for each project provides additional information that is not revealed by computing only present value equivalents ‘ | \se 658“ FIGURE 6.10. Project balance forfour cash flow patterns 6 TIME-DEPENDENT MEASURE OF HoSTMENT WORT: 235 Table 6.4 Statistics of Project Balance Patterns for Projects 1, 2, 3, and 4 Project. unure We Number Cath How Patere _FY(IO%) as ae i ingle payment $534 Rio 0S, 2 Uniform series $534 106; 367-2 3 Gradient series Gecreasing) $634 M27 13382 4 Gradient series increasing) $634 160s (see Figure 6.106). For example, a comparison of project 1 with project 3 in terms of the shape of the project balance pattern shows that project 3 recovers its initial investment within 2 years, whereas project | takes 3 years (o recover the same inical investment This, in carn, indicates that project 3 would provide more flexibility in future investment activity to the firm than project 1. By selecting project 3, the investor can be sure of being restored to his or her initial position within a short span of time. Similar one-to-one comparisons can be ‘made among all four projects. Table 6.4 summarizes the statistics obtained from the balance patterns for each project shown in Figure 6.105, Table 6.4 shows that project 3 appears to be most desirable, even though its terminal profitability is equal to those of the other projects, because its ANB is the smallest and its APB isthe largest among the projects. As discussed in Section 66.1, the small value of ANB implies more flexibility in the firm's furure invest ‘ment activity. In other words, an early resolution of the negative project balance ‘would make funds available for attractive investment opportunities that become(236. rasunes OF iwesTiENT WORTHI—SINGLE FRIES available in the subsequent decision periods. One-to-one comparisons of the projects in terms of ANB and APB can be depicted graphically (see Figure 6.11), From Figure 6.9, it becomes evident thatthe project balance parameters such as ANB and APB reflect Yoe changes in the cash flow patterns over time. Since project 3 represents the highest APB with the smallest ANB, project 3 appears 10 be the most desirable. Of course, the environment in which the decision is made and individual preferences will dictate which of these parameters should be used so that the economic implications of an investment project are fully understood. 6.7 SUMMARY In this chapter we showed the following 1. The PY, FV, and AB will always yield the same decision for a project. We consider PV as the baseline, or “corfect,” criterion to use in a stable, perfect capital market with complete gertainey about investment outcomes. 2. The distinction between pure and mixed investments is needed to deter mine whether the retuen on invested capital is independent ofthe cost of capital 3. Only for a pure investment is there a rate of return concept internal (0 the project. For puce investments, the /RR and PV criteria result in identical acceptance and rejection decisions. 4, The return on invested capital for a mixed project varies directly with the cost of capital, The phenomenon of multiple RRs, which occurs only in the situation of a mixed investment, is actually a manifestation of the existence Of this basic functional relationship. The RIC is consistent with the PV cexiterion, 5. ARR and MIRR will also always yield the same decision for a project, ‘consistent with the PV criterion, 6. Rg, Ry, and L-S ratios will give the Same accept—reject decisions for an individual project. The PV and these B/C ratios will always agree ‘either the payback period nor the discounted payback period should be considered as a criterion, since they may not agree with PV They may be used as additional constraints in the decision-making process, but (ey should be used with caution. 8. The project balance diagram provides quantitative information about four important characteristics associated with the economic desirability of an investment project. Two of these characteristics, net future value (terminal project balance) and discounted payback petiod, have generally been a Daft of conventional economic analyses. However, the other two charac teristics, ANB and APB, have not been considered. Possible applications of the project balance indicate that a variety of measurements can be devised that reflect particular characteristics of the investment project uncer con: sideration. The project balance at the end of a project, PB, is identical to the FV criterion in tradition REFERE sine w Que quen gence Ma Pats Pris vol. 2 Te Rewss 196 Te pp 1