Investment Selection Methods: Static vs. Dynamic Criteria

Posted on Apr 3, 2025 in Finance

Static Criteria

Static criteria do not account for the time value of money. They treat cash flows as having the same value, even when received at different times. This is unrealistic because it ignores inflation and interest rates. Consequently, static criteria can lead to flawed investment decisions.

Examples of static criteria include:

  • Payback period
  • Total net cash flow
  • Net annual cash flow

Payback Period

The payback period represents the time required to recover the initial investment outlay from the accumulated cash flows. It calculates how long it takes for the cash inflows to equal the initial investment. If the recovery time doesn’t fall exactly on a year-end, an approximation is made, assuming cash flows occur continuously throughout the year.

The investment with the shortest payback period is typically chosen, while those failing to recover the initial investment within an acceptable timeframe are rejected.

Disadvantages of Payback Period:

This method can lead to incorrect decisions because it assumes that money generated in different years has the same value, disregarding the effects of inflation and interest. To correct for this, cash flows should be discounted using an appropriate interest rate before comparison.

Dynamic Criteria

Dynamic criteria are more realistic because they acknowledge that amounts of money received at different times cannot be directly compared due to inflation and interest rates. To accurately compare cash flows generated at different times, they must be homogenized by discounting them to a common point in time.

Net Present Value (NPV)

NPV assesses the profitability of an investment by discounting all future cash flows to their present value using a specified interest rate. It is assumed that the market interest rate (i), also known as the discount rate, cost of capital, or cost of money, remains constant.

  • If NPV > 0: The sum of all discounted cash flows, at the market interest rate, exceeds the initial investment. This indicates a profitable investment, as the cash flows cover the initial outlay and generate a profit.
  • If NPV < 0: The present value of all cash flows, discounted at the market interest rate, does not cover the initial investment. This indicates an unprofitable investment.
  • If NPV = 0: The cash flows cover the initial investment, but the investment generates no additional profit. The investment is considered neutral.

Internal Rate of Return (IRR)

The IRR is the discount rate (r) that makes the NPV equal to zero. In other words, it represents the interest rate at which the cash flows exactly cover the initial investment. A higher IRR generally indicates a more profitable investment. To determine if an investment is worthwhile, the IRR should be compared to the market interest rate (i).

  • If r > i: The investment is profitable and yields returns above the market rate. The NPV of this investment (calculated using the market interest rate) will be positive, indicating a benefit.
  • If r < i: The investment is not worthwhile, as the NPV calculated using the market interest rate would be negative, resulting in a loss.
  • If r = i: The investment is neutral, neither generating a profit nor incurring a loss. The cash flows simply cover the initial investment.

When comparing multiple investments, the one with the highest IRR is typically chosen.