LECTURE 5b

Decision Criteria for Investment &

Decision Criteria
Project Appraisal

- Net Present Value (NPV)

- Benefit-
Benefit-Cost Ratio (BCR)
- Internal Rate of Return (IRR)
October 8, 2008

Decision Criteria for Analysis The present value of all costs is:
n
Ct
- Based on the principle that a good criterion should be PV (cos ts ) =
consistent with present value maximization. t =0 (1 + r ) t

1) Net Present Value (NPV) - difference between the The NPV of a management option is then:
total discounted value of benefits and the total discounted
value of costs (5) NPV = PV (benefits ) PV (cos ts )
n n
Bt Ct
=
Let Bt = economic benefits in year t t =0 (1 + r ) t t =0 (1 + r ) t
Ct = economic cos ts in year t
r = guiding rate of int erest ( per year ) Alternatively:
n = duration of the project (in years) n
Bt Ct
(6) NPV =
t =0 (1 + r ) t
Then the present value of all benefits is:

n
Bt Decision Rule: Any project with positive
PV (benefits ) = NPV is worth doing
t =0 (1 + r ) t

Example in calculating NPV

Table 1. Benefits and Costs of Ponderosa-Pine Reforestation Project
2) Benefit-Cost Ratio (BCR) - present value of the
benefits expected throughout the life of a management
option, divided by the present value of the costs
Cost ($) Benefit ($)
Operation Year (1.03)year Current Discounted Current Discounted That is:
n
Planting 0 1 1,460 1,460 B t (1 + r ) t
Precommercial (7 ) BCR = t =0
n
thinning 10 1.344 610 454
C
t =0
t (1 + r ) t
Thinning 30 2.427 200 82 2,270 935

Thinning 50 4.384 200 46 2,280 520

For example, the BCR of the ponderosa-pine reforestation
Final harvest 65 6.830 400 59 15,500 2,269
project described in Table 1, is:

Total 2,101 3,724

3,724
BCR = = 1.77
2,101
The NPV of this project is $3724 - $2101 = $1623

1
A project that has a BCR of 1 has an NPV of 0. To see Likewise, a project that has a BCR > 1 has a positive NPV.
this, we set the BCR in Equation 7 as: While a project that has a BCR < 1 has a negative NPV.
n

B t (1 + r ) t Decision Rule: Any project with a BCR > 1

(7 ) BCR = t =0
n
=1 is worth doing
C
t =0
t (1 + r )t
3) Internal Rate of Return (IRR) - the interest rate in
n n which the NPV of a project is equal to 0
Bt Ct
This implies:
t = 0 (1 + r )
t
=
t = 0 (1 + r )
t From Equation 6 this implies that the IRR is the
interest rate that solves the equation:
n
Bt Ct
And from Equation 5: ( 6) NPV = =0
t =0 (1 + r ) t
n n
Bt Ct
(5) NPV = =0 This equation shows that the IRR is the interest rate
t =0 (1 + r ) t t =0 (1 + r ) t for which the present value of returns/benefits just
balances the present value of costs.

The interest rate is usually a number between 0 and 1. These values can be shown by the following graph:
In that interval, the NPV of most projects decreases as
the interest rate increases.
NPV (r), ($1000)
The IRR can be graphically determined using Equation
6 by the following example. From Table 1 the NPV, at
certain values of r, is defined by the equation:
18
610 2070 2080 15,100 16
NPV ( r ) = 1460 + + +
(1 + r )10 (1 + r ) 30 (1 + r ) 50 (1 + r ) 65 14
12
So, at r = 0, NPV = 17,180 10 Internal rate of return (IRR)
r = .01, NPV = 8,597 8
r = .02, NPV = 4,124 6
4
r = .03, NPV = 1,624
2
r = .04, NPV = 239 5 6 7
0 r (percent)
r = .05, NPV = 541 -2
1 2 3 4

This means that the IRR is between 4% and 5%.

Figure 1. Graphical determination of IRR.

Decision Rule: Accept a project if the IRR > Summary

guiding interest rate; which
means that the NPV > 0.
Decision Criteria:
Fund project or option if NPV > 0
What is the guiding interest rate?
Fund project if BCR > 1
Fund project if IRR > guiding
Private firms - average bank lending rate interest rate

Public projects (e.g. Ontario government Caveat: Determination of non-market benefits

projects) - rate of return of government and costs Use Contingent Valuation Method
bonds (CVM) to derive these values.