Introduction To Investment Criteria

What Are Investments

The allocation of money (or other assets) for the purpose of purchasing new assets including financial instruments <i.e. stocks, bonds>, and/or investment projects (buildings, machinery) with the expectation of profitable returns in the form of interest, income, or appreciation in value.

Minimum Acceptable Rate of Return (MARR)

The minimum acceptable rate of return is a "base case" minimum interest rate used to compare investment options. It is the minimum return on a project that an investor will accept before the commitment of funds.


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Audio Transcript: Minimum Acceptable Rate of Return (MARR), Explained

Investment Criteria

Investment criteria are used to determine whether the reward of an investment outweighs its risk <maximize return/risk>.

There are three main investment criteria:

  1. Present Worth
  2. Annual Worth
  3. Internal Rate of Return


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Audio Transcript: Investment Criteria

Present Worth

Present worth (PW) analysis is an equivalence method of analysis of investment decisions in which a project's cash flows are presented as a single present value. PW is one of the most basic and efficient methods available for determining the acceptability of a project on an economic basis. PW is often referred to as lifecycle costs.

PW analysis takes two forms: simple payback, which ignores the time-value of money, and discounted payback, which accounts for the time-value of money. In this class, the generic term "Present Worth" will almost always refer to discounted payback.

Simple Payback

A computationally simple and straightforward method for determining when a project will break even (i.e., its payback period). Mathematically: Time such that Costs + Benefits = 0.

Simple payback does not use a real interest rate for the minimum acceptable rate of return. Every dollar before the minimum payback period is counted as stated. To calculate simple payback, add up the costs or benefits in each time period through the payback period as though the interest rate were zero. Do not discount costs or benefits. Costs or benefits after the payback period are not considered: it is as if the interest rate (and therefore, the cost) jumps to infinity after the payback period.

Simple payback is often a good criteria to use when deciding whether a more detailed investment criteria analysis should be made, but it is only useful in certain cases. It should only be used when the payback period is short. It is a poor criteria to use when evaluating whether to make long-term investments. When benefits are not in the near future, the results will deviate from those calculated using discounting (present worth) and a minimum acceptable rate of return. Simple payback should not be used for assets that have cyclical costs and benefits over time.

Discounted Payback

Annual Worth

Annual Worth (AW) analysis is an equivalence method of analysis of investment decisions in which a project's cash flows are presented as a annualized series of equal payments.

Synonyms for AW:

  • Levelized cost
  • Capitalized cost (WARNING: present worth is sometimes called capitalized cost, too)
  • Equivalent annual cost
  • Annual equivalent-worth analysis

Internal Rate of Return

A third investment decision making tool in which an interest rate is used so that the net present value of all cash flows from a particular project equals zero. The higher a project's internal rate of return, the more attractive of an investment it becomes.

Bibliography

Park, Chan s. Contemporary Engineering Economics.4th ed. Department of industrial and systems Engineering Auburn University,Upper Saddle River,New Jersey 07458, 2007

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