Decision Criteria Concepts

Properties of a good decision criterion:

• A good decision criteria should make sense. (Benefits exceed costs)
• Unit of measurement. It is very important.
• Benchmark obvious.
• Easy to communicate. You must be able to communicate your thoughts otherwise your understanding will be useless.
• Easy to compare different ideas/projects.
• Easy to calculate
• Others ? . Think yourself.

Concept of Net Present Value (NPV):

Assume an interest rate of r = 10%; what is the NPV of this idea ?

Initially, the cash flow is -$1,000 which indicates the cash flow and in 0 year there is no discounting so present value is -$1,000. When the period becomes 1 year the cash flow is $1320 and its present value or today its value is $1200. Then the NPV is $200.

In Excel, calculating NPV is very simple. And remember it is the present value NPV. Watch the below video to calculate NPV in excel.

NPV (Formula):

The NPV is defined as:

                     NPV = -I₀ + C₁/(1+r) + C₂/(1+r)² + ….. + C_n/(1+r)ⁿ

Where I_0,  C_1, C₂ are investment cost, cash flow in 1 year and cash flow is 2^nd year respectively.

Remember:

            The projects whose NPV are positive are accepted. The negative ones are rejected.

Payback Period: What is the payback period of the following idea?

In above example, you are investing $1000 then how long will it take it to get your investment back. Obviously it is 2 years. That is at the end of 2 years we get out $1000 of investment back. So payback period in this case is 2 years. Now, try the below example again:

In above case,                          Payback period =  2.10 (The $800 you get at the end f 2 years and remaining $200 you get in last year which is 200/2000 is 1/10. so add 2 + 0.1 = 2.10) What will happen to Payback period if you are discounting? The payback will increase. It is because when you are discounting i.e. you are calculating PV of your future cash flows. Then $300 will be less than $300 and $500 will be less than $500 and similarly same with the $2000. So, when cash flows decreases, payback period will increase. Internal Rate of Return (IRR):                           It is the rate at which the NPV will be exactly zero. What is IRR of the following idea?

           Calculation:                                 IRR = (110-100)/100 = 0.1 = 10% It is very simple to calculate. The formula is :                                IRR = (FV- PV)/PV = (110 - 100)/100 = 10%/year or                                IRR = (Final sum - Initial sum)/ Initial sum = Profit/ Investment IRR: Intuition

• What is the NPV, if you use IRR = 10%?

          NPV = -100 + 110/(1+0.1) = 0 (It is very important to understand that your IRR always brings your                                                              NPV 0)

• What if others in this type of business are making 8%?

          Your IRR (10%) > r (8%). That means you are doing great than others. Accept the project.

• What if others in this type of business are making 12%?

          Then, IRR < r. Never accept the project because you are getting 12% in the market for the same                   project then why do you accept the project having less percentage than the market. The above example is very simple. Now try this one:

What do you think? Is the IRR same as Example 1. The answer is NO. How can the IRR for 1 year and also for 2 year be same. So to calculate the above problem, make NPV = 0.                                      NPV = 0                             or,   -I₀ + C₁/(1+r) + C₂/(1+r)²  = 0                             or,   C₁/(1+r) + C₂/(1+r)²   = I₀                                       or,   0/(1+r) + 110/(1+r)2 = 100                             or,   0 + 110/100 =  (1+r)2                       or,   1.1= - (1+r)2                       or,   1.1 ^ (1/2)=  (1+r)                       or,   1.1 ^ (1/2)= (1+r)                       or,   1.0488=  (1+r)                       or,   0.0488=  r                              so, r = 4.88% Using excel, it is even easier to calculate. Use the formula  = IRR(values,guess) in excel. Watch the video below to calculate IRR using excel.