Is It An Investment Or A Loan

Is it an investment or a loan?

The relationships between three criteria must be examined:

Present Worth (PW) tells you how your cash flow would change if you were to take on the project in question, relative to the no-action base level of zero cash flow. Qualitatively, a positive value means your cash flow would increase. Negative means decrease.

Minimum Acceptable Rate of Return (MARR) is the lowest rate at which you will offer up your money. It is based on complicated risk analysis and in this class it is always given if needed.

Internal rate of return (IRR) is the interest rate for which your asset would have a present worth of zero, i.e. the break-even rate, at which you are exactly indifferent between taking on the project and not. If you can invest in a project where your MARR is lower than the IRR, you will have done better than broken even, and you should do it. On the other hand, if you are looking at borrowing money, you want the IRR to be lower than the MARR (if your MARR is lower, you would be better off using your own retained earnings than borrowing).

Four possible PW/IRR/MARR combinations can arise:

 1 2 3 4 PW + + - - IRR vs MARR IRR>MARR IRRMARR IRR

Analysis:

First, consider PW. If it's positive, buy it. If it's negative, don't. If it's zero you're indifferent, but in this class we say go for it.

Consider the assets you've decided to buy:

1. IRR>MARR: Money being used will bring you a greater return than money being sat on. Putting your money into this project has positive present worth to you, so it must be a good investment.

2. IRR<MARR: Money being sat on will bring you a greater return than money being used. Keep your money. Since this asset has positive present worth to you, it must be cheap money from outside, i.e. it must be a good loan.

Now, the assets you didn't buy:

3. IRR>MARR: If this were an investment, you would have chosen to take it because money being used would bring you a greater return than money being sat on. Yet you didn't take it. Why not? It must be a bad loan.

4. IRR<MARR: If this were a good loan, you would have taken it. Yet you didn't take this asset. Why not? It must be a bad investment.

page revision: 2, last edited: 12 Mar 2010 16:05