Audio Transcript: Investment Criteria

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Lets talk a little now about our investment criteria that we are going to be using. And by investment criteria what we are talking about here is how do you decide which investments you are going to make. Whether it is going to be pulling one out of your menu of choices or by taking a couple of these choices that you have on your menu and these are the criteria we are talking about. There are 3 main criteria, present worth, the annual worth criteria, and the internal rate of return criteria. There is also a 4th criteria we are going to talk about briefly.

It is very simple but it actually isn’t quite common use. To guide you through lets talk about the one that’s the oddball. It’s something that’s referred to as simple payback. Simple payback is extremely simple, its how long till I get my money back from my initial investment. If you want a quick example of this, when my son was quite young, he wanted $10 for whatever reason. I said fine but you have to pay me back a dollar per week until you’ve paid me back and I asked him How many weeks will it be till you pay me back? And he quickly said 10. That’s how simple, simple payback is; its how quickly you get back to zero. Now your book says that this is something that's a little on the rare side, it isn't. It is a common first screen that you will find all over the place. And so what you end up doing is before you engaging in any further analysis you a frequently asked what is its simple payback and you can only go forward if it has payback in less than 5 years or in 5 years or less, something along those lines. You will also find it imbedded in a lot of laws and so for example I have in my school district, we recently did some energy efficiency improvements.

In order to get a hold of the money that did it we had to do all projects with simple payback of 15 years or less so it was something that was deeply imbedded in the law. Now part of the reason they do this is it keeps the possibility of arguing about and interest rate out of things even though they’re implicit interest rates in simple payback. It also seems to be a criteria that is easier for larger groups of people to agree on, so people can agree on well lets fund things that go ahead and pay us back within 5 years whereas deciding on an interest rate can be rather difficult, that interest rate being the minimum acceptable rate of return. I want to emphasize that choosing that kind of interest rate can be something that is actually quite contentious, and you can see many organizations struggling over that particular interest rate. The best example I can have on this one is energy efficiency improvements because this is my area of expertise.

Now for many years California struggled with this problem because there were many different ideas about which interest rate to use as a reference interest rate. Some people were advocating that because people were making energy efficiency improvements, buying efficient refrigerators by putting them on credit cards, they should be using the credit card rate in order to do their time value money calculations. Other people noted that often times energy efficiency improvements such as roofs were being imbedded in a second mortgage. So they said mortgage interest rates weren't appropriate interest rate use. In other words other places were saying that since some of these things are being funded by the state, the state has a common bond rate, we should use the state bond rate as the way that we discount these things. Finally still others said that because these things actually promote a kind of social good that the discount rate should be the social discount rate, which tends to be the growth rate of real GDP.

So all these things give you slightly different interest rates and so its extremely common to have a fight about the interest rates because each person is in a slightly different point of view, and its common to go ahead and move towards something that seems simpler in order to avoid the fight. Now the other three criteria are different from simple payback what’s nice about them is they always give you the same choice, they don’t give you the choice in the same way but they will always say that oh you should get the roof or you shouldn't get the roof, they'll all be consistent about that choice.

The first one is present worth and you may think of present worth as the lifecycle cost. You can ask yourself questions like what is a lifecycle cost of buying, maintaining, fueling and insuring an automobile over its lifecycle? That’s the cost we are looking at after you do all the discounting. Now your mind should reel on this because this is something that's really kind of difficult to grasp. That's what present worth is going to be. Some clients are actual like present worth, its easier for them to grasp and it actually computationally something you'll do most often. A lot of clients are going to have difficulty with this idea of taking all the value, all the costs that are there in an investment and focusing it on this one date, its lifecycle cost. Frequently you are going to find clients that are going to prefer the next criteria that we are going to use which is the annual worth criteria.

You can think of this as some kind of levelized cost, which is a phrase, which you will often hear about here. Or an annualized cost but its really a per period cost. You see what I mean by its easier to wrap you head around because you recall that I asked you about the lifecycle cost of a car its easier to go ahead and figure out what the monthly cost of a car is. Because you know about what those payments are going to be, you know about what you'd use in gas, you know about what is costs to insure a car every month so its easier to grasp. While the easier to grasp criteria may not seem important to you, you have got to remember that investment decisions are not entirely made on these kinds of financial considerations. There are ideas about how they mix with other investments that you are making that you haven’t quite gone through the computation on those. There’s ideas about whether this fits in with your ideas about what you want to do with your portfolio of assets even though you haven't explicitly modeled how they're interacting.

And some kind of investments are emotional, they have an emotional content to them, or they have some kind of things which aren't included in the calculation. My example of this one is you can go ahead and analyze which car would be the correct car with your household. But when you sit down with a car you are going to have an emotional response that says I need to have leather seats or I need to have seat warmers, and that’s the kind of thing that gets you. This style of it, something which isn't necessarily bound up in those financial calculations.

Now the final criteria, the other one that is consistent with present worth and annual worth is something that’s referred to as internal rate of return. Instead of talking about the lifecycle benefits like we do in present worth or the per period benefits like we do in annual worth, what internal rate of return talks about is the per dollar benefits we are looking at. Computationally internal rate of return is going to be the hardest criteria to cope with because it is quite computationally intensive and it will be preferred in certain industries. If you're dealing with physical assets, if you are talking about a building, if you're talking about equipment there is a preference there for present or annual worth, but if you are talking about financial investments there is a preference for internal rate of return as a measure.

This is not always going to be easy because frequently there will be many different answers to what’s the internal rate of return. The internal rate of return may actually change a little bit depending upon what day you look at it. So those are our four criteria, the fully consistent one present worth, annual worth, and internal rate of return, and the one that is often used as a screen before you get to the other ones because they are computationally slightly more expensive.

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