Decision criteria depend upon the objective to be achieved through the instrumentality of the decision-making process. The main objectives which a business organization pursues are maximization of return and minimization of costs.
A fair decision criterion should distinguish between acceptable and unacceptable proposals and solve the problem of selection of the best alternatives from amongst the various alternatives available in a given situation to achieve the above objectives. A fair decision criterion should follow the following two fundamental principles i.e. (1) the “Bigger and Better” principle; (2) “A Bird in Hand is Better than Two in the Bush” principle. The first principle suggests that bigger benefits are preferable to smaller ones; whereas the second one suggests that early benefits are preferable to later benefits.
Decision criteria in financial management can be studied under two separate heads viz. The criteria for investment decisions; and the criteria for the financing decisions.
Criteria for investment decisions are mainly concerned with planning and control of capital expenditure through budgeting process following the tools of analysis viz. payback period, accounting rate of return, discounted cash flow methods e.g., net present value method, etc. However, the essence and the inherent spirit in these techniques are based on logic which helps in the decision-making process.
Both the above principles are based on the assumption of “other things being equal” which is a rare reality. But in practice, the decision process very much adheres to these principles particularly in the areas of capital budgeting decisions and determining the cost of capital in project financing proposals.
As a matter of fact, these techniques have been founded on the following decision criteria:
1. Urgency: The use of ‘urgency’ is treated as the criterion for the selection of investment projects in many corporate units/ business enterprises/government set up. Urgency is assessed on the following basis:
(a) it provides sufficient justification for undertaking a project;
(b) it provides an immediate contribution to the attainment of objectives of the project;
(c) it maximizes profits.
Although urgency as a criterion lacks objectivity, being non-quantifiable, yet it definitely provides an ordinal ranking scale for the selection of projects on the preferential pre-exemption basis.
2. Payback: Time is of essence while selecting this criterion for investment decisions. The decision is taken on the basis of quickness in pay off the investments. Payback simply measures the time required for cash flows from the project to return the initial investment to the firm’s account. Projects, on the basis of this criterion, having quicker paybacks are preferred. The payback decision criterion does not follow the principles laid down above viz. “the bigger and better” and “bird in the hand”. It ignores the first principle completely as it does not take into account the cash flows after the investment has been recovered. It also does not satisfy entirely the second principle as it assigns zero value to the receipts, subsequent to the recovery of the amount.
3. Rate of return: It provides another decision criterion based on accounting records or projected statements to measure profitability as an annual percentage of capital employed. The rate of return is arrived at following two different methods for treating income in the analysis which gives different results. In the first case, the average income generated from investment is taken after the deduction of the depreciation charge. In the second case, the original cost is taken as a denominator rather than an average investment. This gives the simple yearly rate of return. This is based on the “bigger and better” principle. This criterion can be applied either against average investment in the year selected for study or simply against initial cost.
4. Undiscounted benefit-cost ratio: It is the ratio between the aggregate benefits and the cost of the project. Benefits are taken at face value. The ratio may be “gross” or “net”. It is “gross” when calculated with benefits without deducting depreciation. In the net version, depreciation is deducted from benefits before computing the results. Both ratios give an identical ranking. Net ratio equals the gross ratio minus 1. This relationship makes it simple to calculate the gross ratio and then to arrive at a net ratio.
5. Discounted benefit-cost ratio: This ratio is more reliable as it is based on the present value of future benefits and costs. It may also be gross or net like the one discussed earlier. It takes into account all incomes whenever received and to this extent complies with the “bigger and better” principle. Early receipts are given more weight than late receipts on account of the introduction of the discount factor.
6. Present value method: This concept is useful as a decision criterion because it reveals the fact that the value of money is constantly declining as a rupee received today is more in value than the rupee at the end of a year. Besides, if the rupee is invested today it will fetch a return on investment and accumulate to Re. 1 (1+i) at the end of the ‘n’ period. Hence a rupee received at the end of the ‘n’ period is worth 1/(1+i)n now. Investment decisions require comparison of present value with the cost of assets, and if the present value exceeds the cost, the investment is rendered acceptable.
7. Internal rate of return: It is a widely used criterion for investment decisions. It takes the interest factor into account. It is known as the marginal efficiency of capital or rate of return over cost. It stipulates the rate of discount which will equate the present value of the net benefits with the cost of the project