Volume 3 (17) Issue 4 2012

Selection of Investment Projects in Situations of Discordance

between Criteria of Efficiency Assessment
Mihai MIEIL
Valahia University of Trgovite, Romania
m_mieila@yahoo.com

Abstract
The appraisal of efficiency in investments is based on a system of indicators having as
source the specific methodology applied by the International Bank for Reconstruction and

Development. Commonly, by applying the efficiency appraisal criteria, result consistent

outcomes. That implies the immediate possibility for settlement of the preferred project,
from a pool of mutually exclusive projects. In this paper, there are presented examples that
prove this concordance is not always achieved. That is, from two mutually exclusive
projects, the efficiency assessment based on one criterion results that one project is
preferred; based on other criterion is preferred the other project. Usually, these types of
conflicts appear when there are used the Net Present Value on the one hand, and the
Internal Rate of Return and the Payback Period methods, on the other hand. The paper
discusses the source of this discordance, the underlying assumptions and of these methods,
and the ways of solving these types of difficulties, having as starting point the purpose and
the objectives in implementation of the specified project.
Keywords: investments, efficiency, appraisal, criteria, indicators
JEL Classification: M21

Introduction
The investment policy must be based on universally recognized and accepted
criteria in project selection. A decision regarding the opportunity of investing in one
particular project or to choose between several options is reliable when it is based not on a
single criterion of efficiency, but on a complex of complementary characters that are
considered representative.
The presentation of these criteria shows that the discount rate, the net present value
and payback period are indicators that quantify the criteria that can lead to "a priori" choice
to invest between others (Toplicianu & Badea, 2006: 144).
The basic conditions that an efficiency appraisal criterion must meet are: easy to
formulate, to synthesize the purpose, to be expressed as far as possible through a
mathematical function and, in order to measure the economic efficiency, to be measurable
by at least one indicator (Ioni, 1994: 125).

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1. Net present value and the internal rate of return
In the process of efficiency appraisal, the companies use both the NPV and IRR
methods. However, the two criteria provide different points of view on the project, and this
may lead to conflicting results.
In the figure 1 is presented the change of net present value (NPV) based on the
discount rate. The net present value is a decreasing function, which intersect the axis in a
point corresponding to a certain discount rate called internal rate of return (IRR). The
curves represented describe two distinct projects A, and B, characterized by NPVA and
IRRA and, respectively by NPVB and IRRB.
Figure 1.
Change in net present value based on the discount rate
NPV

NPVB
NPVA
IRRA
Discountrate
a

IRRB

(Source: Adapted after Halpern and al., 1998: 427)

There might be observed that, when comparing the two projects using only the
IRR criterion, the decision would be favorable to the project A; if would be used the NPV
as selection criterion, for a discount rate superior to "a", then decision would be favorable
to the project A. If it is used the selected value "a" of the discount rate, that determines the
intersection of the two curves (NPVA and NPVB) and no difference between the two
projects. Using a discount rate lower than "a", determines a decision favorable for the
project B.
The NPV has the advantage of being an additive measure, expressed in monetary
units, as a more suggestive feature. Its value is based on the discount rate proposed by the
investor depending on specific conditions (Bichler & Nitzan, 2010: 10).
IRR is not an additive measure, but it represents the concept of return rate applied
to the specified project. This concept is relatively familiar to the beneficiaries of a
feasibility study. However, if the IRR expresses a decision criterion to invest in a given
project (IRR>discount rate) the usage and the utility of this criterion in comparing different
projects must remain limited. This is caused by the fact that the internal rate of return of a
particular project is, by definition, only fictitious discount rate that determines zero value
of net present value. In situation of comparison of two or more projects mutually
exclusive, the internal rates of return are different, implying different discount rates. This
is a fluid-based reasoning, in case of the same investor.

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Therefore, the IRR is a suitable criterion that has to be used primary role in
assessing projects efficiency under the situation of external financing. Thus, considering
the example illustrated by the previous chart, the decision for a project has to be
considered as a result of the discount rate effectively used, as follows:
- Case 1: if the discount rate is lower than "a", then the second project generates
superior amount of cash-flows, depicted by superior NPV;
- Case 2: if the IRR for the second project remains superior to the loan rate, it is
obviously a favorable decision for this project;
If the firm has to choose between two mutually exclusive projects, using NPV and
IRR methods for assessing efficiency, this may lead to discordant results. NPV may
indicate one project as the most valuable, while the IRR method may suggest that other
project should be accepted.
The NPV presented in the figure 1 does not take into account any previous loans.
An important note regards the fact that the projects efficiency has to be firstly assessed
from the own profitability point of view, no matter the financing sources.
Example 1. Let us consider two projects, A and B, whose cash flows are shown in
the table 1.
Table 1.
Net cash flows of investment projects
(conventional monetary units)
Year
0
1
2
3

Project A

Project B
-2500
2000
1000
300

-2500
300
1200
2100

Their corresponding values at different discount rates are presented in the table 2.
Table 2.
Net cash flows of investment projects
(conventional monetary units)
Discount rate
0%
5%
7%
10%
15%
20%
25%

Project A

Project B
800
544
456
336
167
29
-85

1100
655
507
311
43
-168
-333

Calculating, results that that IRRA = 21% and IRRB = 16%. Due to later occurency
of major cash flows for Project B, they are affected in a more important manner by the
discounting effects. As result, the NPV for this project plunges dramatically with
increasing discount rate. This example depicts the situation of net present values of the two
projects profiles presented in figure 2.

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Figure 2.
The Net Present Value profiles for two mutually exclusive projects

NPV

NPVB

NPVA

1100

IRRA

10

15

20

25

Cost of capital (%)

IRRB

The discordant results arise from differences in project size or timing. When there
are differences in the amount or timing, the company will have to invest different amounts
in different years, depending on the preferred project.
If the decision is for a project with a reduced investment amount, the company will
have additional funds to invest at time t = 0. Similarly, the two projects of the same size,
the one that generates larger and earlier cash inflows will provide available funds for
reinvestment soon. Due to this situation becomes very important interest rate at which
different cash flows can be reinvested.
2. Net present value and the payback period
Besides the situation presented above, another discordant issue may occur when
considering the net present value and the payback period (PBP) as methods for assessing
the efficiency of the projects. Let us consider the previous example.
If there is considered a discount rate of 7%, which might be considered normal
(including a risk premium of 2%), the project B has a superior NPV. The figure 3 presents
the evolution over time of cumulative cash-flows of the two projects through the curves of
those endpoints in the year N.
This analysis brings in attention other additional information:
- Although the project 2 is more profitable, it is characterized by a longer period
time of up to recovery the capitals; therefore, this project is more difficult to be financially
sustainable, up to reach positive cumulative cash flows;
- Project 2 has a higher payback period as a result of late higher positive cash
flows.
As the situation presented in the above paragraph, the use of the two methods
(NPV and payback period) leads the decision maker to opposite conclusions. Therefore,
the decision is guided on rather subjective criteria, related to the investor's personality and
his/her vision regarding the risk:
- if one prefers to take a higher risk by investing capital with later payback,
having as reward the higher profits, then the project B is to be chosen;

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- otherwise, if the investor has aversion to risk and prefer to limit his/her
financial commitment, recovering the capital faster and accepting the challenge for a lower
profitability, then the project A is to be preferred;
- another point of view regards the scarcity of resources; if these are limited, the
investor is forced to invest in project A.

Figure 3.

Cumulativecashflows

The concomitant evolution of net present value and payback period

500

NPVB

450
NPVA
PBPA
1

ProjectA
ProjectB

PBPB

Time(years)

It is remarkable that, in practice, the payback period represents an important

method of guidance for the investors (Halpern, 1998: 429). This approach is obviously
conservative, meaning that minimizes the risk to the future; nevertheless, the association
risk-future is unjustified, when it refers to proven technology and reliable products.
2. The hypothesis of reinvestment rate
The focal point in the conflict resolution is: how profitable is to have cash flows
sooner and not later? Decision rules for NPV and IRR methods are based on different
assumptions regarding the reinvestment rate. NPV method assumes implicitly that the
inflows generated by the project will be reinvested at cost of capital, while the IRR method
assumes that the company will reinvest these amounts at a rate equal to the IRR. These
assumptions are inherent to the mathematical discounting process used in the two methods.
It is obvious that the correct assumption on the rate of reinvestment rate can only be the
cost of capital. Therefore, NPV method is preferred by the companies which have the
possibility to raise capital at a cost close to the current cost of capital.
In our opinion, the establishment of the discount rate normally used in efficiency
calculations is the most important part of quantifying the influence of the time factor.
In connection with the formation process and size of the discount rate the
economist expressed various opinions. Hereby, the discount rate is considered as an
expression of the "marginal efficiency" of capital (Keynes, 1936: 159, Stefan, 2009: 84).
Thus, the discount rate reflects the importance assigned to future expenditures; in this
approach, the discount rate is considered as the minimal limit of investments efficiency
requested throughout the economy, in order to achieve the optimal economic balance and
growth rate. In fact, the size of discount factor is determined by very tangible economic

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proxies, such as interest rates, capital supply and demand, and the average rate of
profitability. The existence of capital market allows entrepreneurs to borrow a certain
amount of money at present, and to return that amount at a future time, paying extra the
interest, as the price of capital. Therefore, it is necessary that the profit to be obtained by
investing that amount to be superior to the interest about to be paid for the loan. Otherwise,
the entrepreneur can choose either to give money to the bank to get interest, or to invest
and obtain at least the profit corresponding to average rate of interest (Baker, 2000).
It is obvious that these options have as fundament economic and mathematical
calculations, in order to take into account, besides the aspects above mentioned, the risk
and uncertainty specific to the investment process. As the risk increase, the earnings
requirements evolve accordingly. As the discount rate increases, the investors interest in
investing reduces or disappears. Therefore, the discount rate is formed in a range that has a
lower limit, given the interest rate, and an upper limit given by the average rate of return
(figure 3).
Figure 4.

Range of forming the discount rate

Rate
Average rate of return
Domain of forming the
discount rate
Interest rate
(Source: Capet, 1992: 102)

Time

These (upper and lower) limits do not consist themselves as barriers for all
economic branches. Thus, for some areas entailing large risks, the discount rate increases
with the risk premium. It represents the returns expected by investors, over and above the
rate of interest, to compensate for extra risk assumed by investing. From the computational
point of view, the underlying idea of this augmentation in discount rate is to ensure the
pay-back of investment funds in a period of time as reduced as possible. In this regard, it is
noteworthy that in the United States, for certain projects that require a high degree of risk
(the branches with pronounced effects of obsolescence), the discount rate reaches 25-45%,
under an average interest rate of approximately 5%.
Under these conditions, the discount rate includes, in addition to interest rate and a
certain risk premium determined by industry or investment objective.
Nevertheless, the presence of risk in investments has also at least one positive
facet. In the literature there is denoted that the risk leads corporations to finance their
projects partly by debt (Baumol, 1964). The appeal to credit rather than to equity has two
main underlying matters: first, the hope of attracting funds from investors, as a way to limit
the risk; secondly, since the corporate income taxes does not apply neither to the interest
payments on debt, nor to the earnings of firms which have avoided the corporate form of
organization. Therefore, the appeal to borrowed capital determines a diminution of
opportunity cost of financing resources.

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Due to administration, by monetary authorities, of money, credit and interest rates,
through the discount rate, open market operations and minimum reserve system, it is
obviously that, in fact, the form the discount rate and expresses a policy of economic
growth. Considering the nature of the discount rate and trying to find different methods to
determine its scientific some economists have concluded that the discount rate is a
category closely related to macroeconomic growth (Masse, 1964; Ternier, 1971). In fact,
the discount rate can be considered as a "guarantee price" paid by the present in order to
achieve future growth. This means providing to investment projects the amount of
available resources to meet those needs. Obviously, in accordance with the law of faster
aspirations growth, the necessary of investment is always higher than the opportunities
society at that time. Plotting and resources investment when investments are updated, we
see that they intersect at a point which determines the rate itself is updated (figure 4).
Figure 5.
Correlation between the macroeconomic available resources and the discount rate
Resources
I (required
investments)
R (Available resources)

Equilibrium discount rate

Discount rate

(Source: Capet, 1992: 106)

Situations and developments on various markets are, simultaneously, cause and

effect on future behavior of economic agents. Under favorable conditions, when credit is
cheap, money has a high volume, currency exchange rate is favorable, optimism and low
interest rates will lead to a reduced discount rate. If the situation is unfavorable, this
situation will be reflected in an increased risk, which causes an augmentation in discount
rate.
Conclusions
In the efficiency assessment process, there has to be taken into account the
financial position and the objectives pursued by the investor, through the project. If the
evaluator is interested by the added value of project will bring to existing shareholders
capital, assuming materialize of estimated cash flows, then the NPV is the suitable method.
On the other hand, the internal rate of return method shows the rate of return on investment
in the project, according to materialize of initial estimates, focusing on the rate of return to
the project. If the two measures lead to discordant results, under the assumption that the
main goal of firms management is to maximize the value of the firm, then the financial

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management of investments projects should seek to maximize the cash flows generated by
the projects rather than the rate of return.
In case of evaluation the profitability of isolated projects, the key issues of the
analysis consist of: a positive value of the NPV; a value of the IRR superior to the discount
rate considered as normal, or a value of the IRR superior to the contracted loan rate (Capet,
1992: 125). Concomitant there has to be assessed the payback period depending on the
specific industry or through the investors point of view (usually, payback period under
three years). If there are evaluated several mutually exclusive projects, then may preferred
one that will have the higher NPV, and using the IRR has just the role to check whether
there might be interesting to take advantage of a loan leverage.
It is remarkable that, in practice, the payback period represents an important
method of guidance for the investors. This approach is obviously conservative, meaning
that minimizes the risk to the future; nevertheless, the association risk-future is unjustified,
when it refers to proven technology and reliable products. Therefore, thus approaches may
result in economic non-senses, which overlook that the fundamental underlying intention
of an investment is to produce wealth, regardless the medium or long term; achieving the
wealth goal, the payback is realized.
The focal point in resolution of the inconsistent results of efficiency assessment
methods consist in establishment of the discount rate normally used in efficiency
calculations. The most common proxies in this demarche are proxies such as interest rates,
capital supply and demand, and the average rate of return. For a long period of time there
were considered that, giving the increasing efficiency, the markets reached a development
that allow them to fully self regulate, regardless the situation. Nevertheless, the growingefficiency and the self-adjustment type of the market behavior proved resounding failures,
of those echoes are obviously in the nowadays economic situation. Results in the necessity
of duplicate the efficiency by supervision, in order to ensure the dynamic correlation
between the discount rate and the rate of economic growth.
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