introduction to decision criteria

8/15/2019 Introduction to Decision Criteria

1/12


2/12

r does not come rom your pro"ect

*hink o r as the return rom a simi#ar pro"ect8competito

:o. much va#ue you have created

N$%

N$% is a#.ays incrementa#

%a#ue creation is a#.ays incrementa#, It is not abso#ute,

Wa#mart se##s the same but addin+ more va#ue to

0rom be#o. N$% ; incrementa# va#ue created


3/12

$roperties o N$%

Makes sense (Benefts 3/ost) *%M

o We are discountin+ that time has passed

o We use r

Units o Measurement > <

Benchmark obvious

o N$% @ '

o We use r .hich is the competitor9s return ra

asy to communicate

asy to compare ideas and pro"ects

asy to ca#cu#ate

o asier because o exce# , ar#ier compoundin

N$% misses the ?exibi#ity

o It has the static vie. o the .or#d ater toda

o Because it predicts uture cash ?o. it misse

o ea# 4ptions he#ps in this re+ard

$ayback Cpendin+


4/12

Benchmark obvious

No benchmark

asy to communicate

&es, But 0a#se,

asy to ca#cu#ate (4n#y stren+th)

&es

1ra.back

Myopia

:un+ry or cash ?o.s

1oes not reco+niEe #on+ term va#ue

$ro" 2> 3''' F & ;''' F &6 don9t kno.

$ro" B> 3'''F & ; '' F & ; Bi##ion F H1 $ro"ec

/ounter to va#ue creation

Who uses

Ne. /4 to sho. that there are returns

I

I /ompetes .ith N$%

/onsider the pro"ect 2,

&ear /0 &ears rom

today> n

' 3'' '

'

4n ho. much did I make


5/12

o 2nd r ; (0ina# sum 3 Initia# sum)8Initia# Cum

is the rate .hich transormed the initia# investm

o Cubstitutin+ I or N$% ormu#a #eads to '

It does not incorporate environmenta# actors(e,+,, Interest rate or i

idea,

When I ca#cu#ate the '= rate o return and use that same I base

ca#cu#ate the N$% o the idea I am usin+ the ideas return to ca#cu#a

Because I am usin+ o.n rate o return to ca#cu#ate my o.n va#ue I9#

Is this +ood idea

o Invest '' and +et 3''

o But there is not benchmark , 1on9t kno. .hether '= is

o I this business is risky and even 6'= is not +ood then t

o What i others in this type o business are makin+ K=

*hat is r the discount rate .hich is used in the N

*hen the '= idea is a +reat idea, Because everyb

N$% o the idea at K= is @ '

o What i others in this type o business are makin+ 6=

N$% is 3ve

*hus I by itse# is not useu# .ithout benchmark

My $ro"ect 29s I is '=, Is this a +ood idea,

&ear ' &ear

3'' ' '= return N$% ; ' i r ; I

Cay r ;

K=

N$% ; 3'' 7 ' 8

(,'K)

N$% @ ' as others are ha

#ess return than me

Cay r ;

=

N$% ; 3''7'8

(,)

N$% L '

*hus i r @ I then N$%


6/12

Mu#ti3period

prob#em

.hi#e

ca#cu#atin+

I

N$% ; 3'' 7 ' 8( 7r )

In the above +raph p#ot the o##o.in+

I r ;' N$% ; '

I r '= N$% ; '

I cannot .ork by itse#, In order to make decisions .e need to c

peop#e are makin+

$rob#em 6>

&ear /0 &ears rom

today> n

' 3'' '

'

6 ' 6

What is the I over 6 years

I ; '= over 6 years

But this is not comparab#e to prev, prob#em a the prev, one .as y

*hus make N$% ;'


7/12

N$% ; 3'' 7 ' 8(7) 7 '8(7)6

I 6 years becomes year then ; '=

But no. the return is 6 years,

I you say = it is #ike stabbin+ the $roessor as you are i+norin+ c

*hus I L =

xce#>

; irr (3'''') ; ,KK=

:ere .e thro. a## the va#ues un#ike N$%

/ross check .hether ,KK= is correct

;$%(,'KK no,o periods ;6 pmt ;' 0% ;') ; ''

In a mu#ti3period pro"ect .e need to eOuate N$% ;' to f+ure out I

,KK= is @ ' but to "ud+e .hether my business is addin+ va#ue I n

are doin+

In banana business ,KK= is +reat , But i you are makin+ ipad th

.hether others are addin+ more va#ue,

Mu#tip#e I &ear

&ear /0 &ears rom

today> n

' 3'' '

65'


8/12

6 356 6

xce#

Irr(3''65'356)

Irr(3''65'356',6) F ',6 is the +uess

We can +et as many Is as the chan+e in si+n

Co#ve +raphica##y in such a case

asiest N$% to +uess is or I ;'

I I ; N$% is 3ve

W are hopin+ that r is such that '=LrL6'=

I > Mutua##y

xc#usive

$ro"ects

&ou can choose one amon+ severa# pro"ects

N$% is creatin+ va#ue and addin+ va#ue and hence meas

2mon+ mu#tip#e pro"ects most peop#e .ou#d choose a p


9/12

I Bias>

I #ikes short term pro"ect , $ayback is more b#atant about it

$ro"ect 2>

36''' ''6''

I ; 6'=

$ro"ect B

36'''6'''P6

I ; 6=

*he rate o return per year over 6 years is 6=

$ro"ect 2 +ives /0 #ater

$ro"ect B +ives /0 ear#ier

/omparin+ t.o pro"ects #ike that is not +ood , Because I am compari

Instead .e need to consider the cost o capita#

I r; = or 6'= or =

= 6'= =

$ro"ect

2

D,K6 ','' 5'K,6

$ro"ect

B

D,PP '',PQ 5'Q,'D

$ro" 2 at re#ative#y

#o. rate o

eturn or

competition

$ro" B at hi+h

opportunity cost

4 rate o return

Indi!ere

t


10/12

Graph>

I r is @ 6= ie .hat competition is earnin+ .e choose neither

I r is L = .e choose $ro" 2

I is biased to.ards pro"ect .ith ear#y cash ?o.

I bias 6 3

Cma##

Investment

Bias

$ro"ect 2 > 3''' D'' F I ; '=

$ro"ect B> 3'''' P6'' F 6=

I is a ratio Bi++er denominators tends to decrease the ratio, It

; = 5'= m66R

R= 66 5K > $ro"ect B

R5'= DPQ 3Q65 F $ro"ect 2

R66= K 65' F 2#most indi!erent

Graph

I competition is #ess than 66= choose B over 2


11/12

/omparin+ I direct#y and choosin+ the hi+hest one makes us cho

pro"ects, :o.ever #on+ term va#ue creation is important

$roperties o

I

Makes sense

May Be

Because rates o return comes natura##y to us

Sot o thin+s are seemin+#y ri+ht

Unit o measurement

=

/oo# it is unit ree

But .hat is the re#ation b8. va#ue measurement a

%a#ue measurement is usua##y in do##ars or rupees

ven i .e have I .e have to compare .ith the

2s it direct#y not in va#ue

Benchmark obvious

But .e are #ookin+ interna##y,

In do##ars .e are direct#y dea#in+ .ith va#ue

What .ou#d have I earned e#se.here is to be consi

asy to communicate

&es, But Is it

But to see .hether it adds va#ue .e need to comp

asy to compare ideas

2bso#ute#y not


12/12

It is biased

$rob#ems

introduction to decision criteria

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