Disagreement among Investment Criteria—A Solution to the Problem

Abstract

Three standard investment criteria, benefit-cost ratio (B/C), internal rate of return (IRR), and present net worth (PNW), are commonly used for economic evaluation of range improvements. Unfortunately, as commonly calculated, these three criteria often yield contradictory selections when choosing between two or more possible range improvement projects. Disagreements among the three criteria are caused by differences in project lives and initial investments (size), along with failure to recognize explicitly the rate of return foregone on alternative investments. This paper demonstrates that when projects are normalized for non-uniform lives and differences in size, the three investment criteria yield identical project selections. Correct project selection by B/C requires normalization for non-uniform size, while the IRR calculations must be normalized for differences in both project size and expected life. The following procedure is recommended for selecting an optimum combination of projects from among numerous alternatives: (1) Rank projects by B/C. (2) Select best projects first until available capital is exhausted. (3) Perform PNW side calculations to verify the accuracy of the selected project combination.