When making investment decisions, investors often use multiple criteria to evaluate potential opportunities. Common investment criteria include net present value (NPV), internal rate of return (IRR), payback period, accounting rate of return (AAR) and profitability index. Each criterion has its own advantages and disadvantages. NPV is considered the best method as it directly measures the value added, but requires estimating future cash flows and discount rates. IRR is closely related to NPV and gives the same result for independent projects, but can be misleading when comparing mutually exclusive projects. Payback period is easy to understand but ignores the time value of money. This article will elaborate on the core investment criteria with examples to provide useful insights for making informed investment decisions.
NPV as the best criterion for investment evaluation
Net present value (NPV) is considered the best investment criterion as it directly measures the value added or shareholder wealth created. NPV calculates the present value of all future cash flows minus the initial investment. A positive NPV indicates the investment adds value, while a negative NPV means value is destroyed. A key advantage of NPV is that it considers all cash flows over the life of an investment and accounts for the time value of money by discounting future cash flows to present value. However, NPV requires estimating future cash flows and the appropriate discount rate, which can be challenging. Despite this, NPV remains the superior criterion for investment decisions as it aligns with the core goal of maximizing shareholder wealth.
IRR’s close relationship with NPV
Internal rate of return (IRR) is closely related to NPV. IRR is the discount rate that results in a NPV of zero for a project. Investments are acceptable under the IRR rule if the IRR exceeds the required return. For independent projects with conventional cash flows, IRR gives the same result as NPV. A key advantage of IRR is it only requires knowing the investment’s cash flows, without needing to estimate NPV’s discount rate. However, IRR can be misleading when comparing mutually exclusive projects, or investments with unconventional or financing-type cash flows. Overall, NPV remains superior but IRR provides a helpful supplementary perspective in some scenarios.
Simplicity but limitations of payback period
Payback period measures how long an investment takes to recover its initial cost from its cash inflows. It is easy to understand and compute. However, payback period ignores the time value of money and cash flows after the payback point. It may cause firms to favor short-payback projects over better long-term investments. While simple, payback period should not be relied on solely given its limitations. It is best used together with methods like NPV that capture all relevant factors.
Other criteria and use of multiple evaluation methods
Other investment criteria like accounting rate of return (AAR) and profitability index also exist. However, NPV remains the best single metric. In practice, firms often use multiple criteria because NPV estimates can be imprecise. Criteria like IRR and payback period provide additional perspectives to assess if an estimated positive NPV seems reasonable. However, when options conflict, NPV should dominate as it best indicates value added. Overall, NPV, IRR and payback period form the core set of criteria used to evaluate potential investments in practice.
NPV, IRR and payback period are the most widely used investment criteria. NPV is considered the best single metric as it directly measures value added. IRR provides a complementary perspective. Payback period is easy to use but has limitations. Using multiple criteria provides more insights but NPV should drive final decisions.