Here's a complete explanation in detailed paragraph format of:
Various Investment Criteria
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period
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? Various Investment Criteria
Investment criteria are the financial techniques or methods used to assess and compare different investment or project alternatives. These criteria help in determining whether a project is financially viable, how profitable it is, and whether it aligns with the company’s risk-return expectations. The main goal of using investment criteria is to allocate funds to the most efficient projects. Some of the widely used investment appraisal criteria include:
1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
3. Payback Period
4. Profitability Index (PI)
5. Accounting Rate of Return (ARR)
Each method has its own advantages and limitations and is used depending on the nature of the project, time frame, cash flow patterns, and risk level. Among these, NPV and IRR are the most preferred methods in capital budgeting, as they consider the time value of money.
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? Net Present Value (NPV)
Net Present Value (NPV) is one of the most important and widely used investment evaluation techniques. It calculates the difference between the present value of cash inflows and the present value of cash outflows over a project's life. NPV considers the time value of money, making it a more accurate measure of a project’s profitability.
Formula:
NPV = \sum \frac{C_t}{(1 + r)^t} - C_0
= Cash inflow in year t
= Initial investment
= Discount rate
= Time period
If the NPV is positive, it indicates that the project is expected to generate more cash than it costs, and hence it should be accepted. If NPV is negative, the project will reduce the value of the firm and should be rejected.
Example:
If an investment of ₹1,00,000 yields cash flows of ₹30,000 for 5 years and the discount rate is 10%, the NPV can be calculated. If the result is +₹15,000, it means the project will increase the firm’s value by ₹15,000 and should be accepted.
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? Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the discount rate that makes the NPV of all future cash flows from a project equal to zero. In simpler terms, it is the expected annual percentage return that the project is likely to generate.
Decision Rule:
If IRR > Required Rate of Return → Accept the project
If IRR < Required Rate of Return → Reject the project
IRR is a popular investment criterion because it provides a percentage measure, which is easier to compare with a company’s target return or cost of capital.
Example:
If a project costs ₹1,00,000 and yields annual cash flows of ₹25,000 for 5 years, and the IRR is calculated as 14%, and the company’s required rate is 10%, then the project is acceptable.
Limitation:
When cash flows are irregular or change signs multiple times, IRR may give multiple or misleading results. Also, it doesn’t work well when comparing mutually exclusive projects with different scales.
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⏱️ Payback Period
The Payback Period is the time it takes for a project to recover its initial investment through cash inflows. It is one of the simplest methods of investment appraisal and is commonly used for preliminary screening of projects.
For uneven cash flows, the payback period is calculated by adding the cash inflows year by year until the cumulative inflow equals the initial investment.
Example:
If a project costs ₹80,000 and generates ₹20,000 annually, the payback period is:
80,000 / 20,000 = 4 \text{ years}
If the project gives ₹20,000, ₹25,000, ₹15,000, and ₹20,000 over 4 years, the payback will be around 3.5 years by calculating the cumulative inflows.
Limitations:
It ignores the time value of money
It ignores cash flows after the payback period
It focuses on liquidity over profitability
Despite its limitations, it's useful for quick decisions in small businesses or high-risk environments where faster recovery of funds is preferred.
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✅ Conclusion
Each investment appraisal method provides a different lens to evaluate project feasibility. NPV focuses on value creation, IRR indicates return efficiency, and Payback shows how quickly investment can be recovered. A smart investor or manager often uses a combination of these methods for better decision-making, depending on the size, risk, and duration of the investment.
