MAKING INVESTMENT

DECISIONS

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 INTRODUCTION
• Capital budgeting is the allocation of funds to long-lived capital projects.
• A capital project is a long-term investment in tangible assets.
• The principles and tools of capital budgeting are applied in many different
aspects of a business entity’s decision making and in security valuation and
portfolio management.
• A company’s capital budgeting process and prowess are important in valuing a
company.

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 THE CAPITAL BUDGETING PROCESS

Step 1 Generating Ideas

• Generate ideas from inside or outside of the company

Step 2 Analyzing Individual Proposals

• Collect information and analyze the profitability of alternative projects

Step 3 Planning the Capital Budget

• Analyze the fit of the proposed projects with the company’s strategy

Step 4 Monitoring and Post Auditing

• Compare expected and realized results and explain any deviations

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 CLASSIFYING PROJECTS

Replacement Expansion New Products

Projects Projects and Services

Regulatory,
Safety, and
Other
Environmental
Projects

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BASIC PRINCIPLES OF CAPITAL BUDGETING

Decisions are
The timing of cash
based on cash
flows is crucial.
flows.

Cash flows are Cash flows are on

incremental. an after-tax basis.

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 IMPORTANT CAPITAL BUDGETING CONCEPTS
• A sunk cost is a cost that has already occurred, so it cannot be part of the
incremental cash flows of a capital budgeting analysis.
• An opportunity cost is what would be earned on the next-best use of the
assets.
• An incremental cash flow is the difference in a company’s cash flows with
and without the project.
• An externality is an effect that the investment project has on something else,
whether inside or outside of the company.
- Cannibalization is an externality in which the investment reduces cash flows
elsewhere in the company (e.g., takes sales from an existing company
project).

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 CONVENTIONAL AND NONCONVENTIONAL
CASH FLOWS
Conventional Cash Flow (CF) Patterns

Today 1 2 3 4 5

| | | | | |
| | | | | |

–CF +CF +CF +CF +CF +CF

–CF –CF +CF +CF +CF +CF

–CF +CF +CF +CF +CF

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 CONVENTIONAL AND NONCONVENTIONAL
CASH FLOWS
Nonconventional Cash Flow Patterns

Today 1 2 3 4 5

| | | | | |
| | | | | |

–CF +CF +CF +CF +CF –CF

–CF +CF –CF +CF +CF +CF

–CF –CF +CF +CF +CF –CF

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 INVESTMENT DECISION CRITERIA

Net Present Value (NPV)

Internal Rate of Return (IRR)

Payback Period

Discounted Payback Period

Profitability Index (PI)

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 NET PRESENT VALUE
The net present value is the present value of all incremental cash flows, discounted to
the present, less the initial outlay:
(2-1)
Or, reflecting the outlay as CF0,
(2-2)
where
CFt = After-tax cash flow at time t
r = Required rate of return for the investment
Outlay = Investment cash flow at time zero

If NPV >0:
• Invest: Capital project adds value
If NPV <0:
• Do not invest: Capital project destroys value

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 EXAMPLE: NPV
Consider the Hoofdstad Project, which requires an investment of $1 billion
initially, with subsequent cash flows of $200 million, $300 million, $400 million,
and $500 million. We can characterize the project with the following end-of-year
cash flows:
Cash Flow
Period (millions)
0 –$1,000
1 200
2 300
3 400
4 500

What is the net present value of the Hoofdstad Project if the required rate of
return of this project is 5%?

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 EXAMPLE: NPV
Time Line
0 1 2 3 4
| | | | |
| | | | |

–$1,000 $200 $300 $400 $500

Solving for the NPV:

NPV = $219.47 million

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 INTERNAL RATE OF RETURN
The internal rate of return is the rate of return on a project.
- The internal rate of return is the rate of return that results in NPV = 0.
= 0 (2-3)
Or, reflecting the outlay as CF0,
(2-4)
If IRR >r (required rate of return):
• Invest: Capital project adds value
If IRR <r:
• Do not invest: Capital project destroys value

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 EXAMPLE: IRR
Consider the Hoofdstad Project that we used to demonstrate the NPV
calculation:
Cash Flow
Period (millions)
0 –$1,000
1 200
2 300
3 400
4 500

The IRR is the rate that solves the following?

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 A NOTE ON SOLVING FOR IRR
• The IRR is the rate that causes the NPV to be equal to zero.
• The problem is that we cannot solve directly for IRR, but rather must either
iterate (trying different values of IRR until the NPV is zero) or use a financial
calculator or spreadsheet program to solve for IRR.
• In this example, IRR = 12.826%:

$200 $300 $400 $500

$0  =   −$1,000 +  1
 + 2
 +    +
( 1  +  0.12826 ) ( 1  +  0.12826 ) ( 1   +  0.12826 ) ( 1   +  0.12826 ) 4
3

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PAYBACK PERIOD
• The payback period is the length of time it takes to recover the initial cash
outlay of a project from future incremental cash flows.
• In the Hoofdstad Project example, the payback occurs in the last year, Year 4:

Cash Flow Accumulated

Period (millions) Cash flows
0 –$1,000 –$1,000
1 200 –$800
2 300 –$500
3 400 –$100
4 500 +400

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PAYBACK PERIOD: IGNORING CASH FLOWS
For example, the payback period for both Project X and Project Y is three years,
even through Project X provides more value through its Year 4 cash flow:

Project X Project Y
Year
Cash Flows Cash Flows
0 –£100 –£100
1 £20 £20
2 £50 £50
3 £45 £45
4 £60 £0

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 DISCOUNTED PAYBACK PERIOD
• The discounted payback period is the length of time it
takes for the cumulative discounted cash flows to equal the
initial outlay.
- In other words, it is the length of time for the project to reach NPV = 0.

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EXAMPLE: DISCOUNTED PAYBACK PERIOD
Consider the example of Projects X and Y. Both projects have a discounted
payback period close to three years. Project X actually adds more value but is
not distinguished from Project Y using this approach. Discount rate 5%.

Accumulated
Discounted Discounted
Cash Flows Cash Flows Cash Flows
Year Project X Project Y Project X Project Y Project X Project Y
0 –£100.00 –£100.00 –£100.00 –£100.00 –£100.00 –£100.00
1 20.00 20.00 19.05 19.05 –80.95 –80.95
2 50.00 50.00 45.35 45.35 –35.60 –35.60
3 45.00 45.00 38.87 38.87 3.27 3.27
4 60.00 0.00 49.36 0.00 52.63 3.27

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 PROFITABILITY INDEX
The profitability index (PI) is the ratio of the present value of future cash flows
to the initial outlay:
(2-5)

If PI >1.0:
• Invest
• Capital project adds value

If PI <0:
• Do not invest
• Capital project destroys value

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MIRR

DETAILS PROJECT A PROJECT B

0 -200000 -300000
1 -50000 50000
2 100000 100000
3 120000 150000
4 150000 200000
5 170000 150000
Cost of Capital 15% 16%
Reinvestment rate 12% 12%
MIRR

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XIRR

DETAILS PROJECT A DATE OF INFLOW PROJECT B DATE OF INFLOW

0 -200000 1-1-2014 -300000 1-1-2014
1 -50000 31-12-2014 50000 8-10-2014
2 100000 31-12-2015 100000 10-8-2015
3 120000 1-8-2016 150000 31-12-2016
4 150000 31-12-2017 200000 31-12-2017
5 170000 1-2-2019 150000 31-12-2018
XIRR        

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 POPULARITY AND USAGE OF CAPITAL
BUDGETING METHODS
• In terms of consistency with owners’ wealth maximization, NPV and IRR are
preferred over other methods.
• Larger companies tend to prefer NPV and IRR over the payback period
method.
• The payback period is still used, despite its failings.
• The NPV is the estimated added value from investing in the project; therefore,
this added value should be reflected in the company’s stock price.

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CFO DECISION TOOLS (WORLD)

Results from Graham and Harvey (2001)

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CFO DECISION TOOLS (INDIA)

Results from Anand (2002)

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 NET PRESENT VALUE PROFILE
The net present value profile is the graphical illustration of the NPV of a project
at different required rates of return.

The NPV profile intersects the

vertical axis at the sum of the
cash flows (i.e., 0% required rate
of return).
The NPV profile crosses the hor-
izontal axis at the project’s inter-
nal rate of return.
Net
Present
Value

Required Rate of Return

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 RANKING CONFLICTS: NPV VS. IRR
• The NPV and IRR methods may rank projects differently.
- If projects are independent, accept if NPV > 0 produces the same result as when
IRR > r.
- If projects are mutually exclusive, accept if NPV > 0 may produce a different
result than when IRR > r.
• The source of the problem is different reinvestment rate assumptions
- Net present value: Reinvest cash flows at the required rate of return
- Internal rate of return: Reinvest cash flows at the internal rate of return
• The problem is evident when there are different patterns of cash flows
• The problem is evident when there are different scales of cash flows.
• The problem is evident when the discount rates are not constant.

• Since equation used to estimate IRR is an ‘n’ degree polynomial equation it may
lead to more than one unique solution.

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 EXAMPLE: RANKING CONFLICTS 1
Consider two mutually exclusive projects, Project P and Project Q:

End of Year Cash Flows

Year Project P Project Q

0 –100 –100
1 0 33
2 0 33
3 0 33
4 142 33

Which project is preferred and why?

Hint: It depends on the projects’ required rates of return.

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 DECISION AT VARIOUS REQUIRED
RATES OF RETURN

Project P Project Q Decision

NPV @ 0% $42 $32 Accept P, Reject Q
NPV @ 4% $21 $20 Accept P, Reject Q
NPV @ 6% $12 $14 Reject P, Accept Q
NPV @ 10% –$3 $5 Reject P, Accept Q
NPV @ 14% –$16 –$4 Reject P, Reject Q

IRR 9.16% 12.11%

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NPV PROFILES: PROJECT P AND PROJECT Q

$50 NPV of Project P NPV of Project Q

$40
$30
$20

NPV $10
$0
-$10
-$20
-$30
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10 11 12 13 14 15
% % % % % %
Required Rate of Return

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EXAMPLE: RANKING CONFLICTS 2
Mutually Exclusive Projects
- IRR sometimes ignores magnitude of project

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CONTD...

PROJECTS CF0 CF1 IRR NPV @ 10%

D -10000 20000 100% 8182

E -20000 35000 75% 11818

E-D -10000 15000 50% 3636

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EXAMPLE: RANKING CONFLICTS 3
Multiple Rates of Return
- Certain cash flows generate NPV = 0 at two different discount rates
- Following cash flow generates NPV = $2.53 billion at IRR% of 3.5% and
19.54%

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CONTD…

IRR IRR
TIME CF 3.50% 19.54%
0 -30 -30 -30
1 10 9.66 8.37
2 10 9.34 7.00
3 10 9.02 5.85
4 10 8.71 4.90
5 10 8.42 4.10
6 10 8.14 3.43
7 10 7.86 2.87
8 10 7.59 2.40
9 10 7.34 2.01
10 -65 -46.08 -10.91
  NPV 0.00 0.00

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CROSS OVER RATE
• Specific return required for the projects to have the same net present value
• Helps to determine out of two projects which will be more profitable in the short
and long terms
• Steps Involved in Calculating CoR:
- Find cash flow differences between the projects.
- Calculate IRR on cash flow differential.
- Can subtract cash flows of A from B or vice versa, but better to have first CF
negative.
- If profiles don’t cross, one project dominates the other.

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TWO REASONS NPV PROFILES CROSS
• Size (scale) differences. Smaller project frees up funds early.
• High k favours small projects, higher the opportunity cost, the more valuable
these funds.

• Timing differences. Project with faster payback provides more CF in early years
for reinvestment.
• If k is high, early CF especially is good, NPV_Short > NPV_Long.

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EXAMPLE: CROSS OVER RATE
Year Project A Project B A-B
0 -1000 -1000 0
1 100 500 -400
2 200 400 -200
3 400 300 100
4 500 200 300
5 600 100 500
IRR 14%

Sl. No. NPV Profile NPV A NPV B

1 0% 800.00 500.00
2 6% 452.59 312.73
3 10% 270.78 209.21
4 14% 119.26 119.23
5 16% 52.92 78.57
6 17.73% -0.08 45.46

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 PROJECT ANALYSIS AND EVALUATION

What if we are choosing among mutually exclusive

projects that have different useful lives?

What happens under capital rationing?

How do we deal with risk?

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 MUTUALLY EXCLUSIVE PROJECTS
WITH UNEQUAL LIVES
• When comparing projects that have different useful lives, we cannot simply
compare NPVs because the timing of replacing the projects would be different,
and hence, the number of replacements between the projects would be
different in order to accomplish the same function.
• Approaches
1. Determine the least common life for a finite number of replacements and
calculate NPV for each project.
2. Determine the annual annuity that is equivalent to investing in each project
(that is, calculate the equivalent annual annuity, or EAA).

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 EXAMPLE: UNEQUAL LIVES
Consider two projects, Project G and Project H, both with a required rate of
return of 5%:
End-of-Year
Cash Flows
Year Project G Project H
0 –$100 –$100
1 30 38
2 30 39
3 30 40
4 30

NPV $6.38 $6.12

Which project should be selected, and why?

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 EXAMPLE: UNEQUAL LIVES
NPV WITH A FINITE NUMBER OF REPLACEMENTS

Project G: Two replacements

Project H: Three replacements

0 1 2 3 4 5 6 7 8 9 10 11 12
| | | | | | | | | | | | |
| | | | | | | | | | | | |

Project G $6.38 $6.38 $6.38

Project H $6.12 $6.12 $6.12 $6.12

NPV of Project G: original, plus two replacements = $15.95

NPV of Project H: original, plus three replacements = $19.92

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 EXAMPLE: UNEQUAL LIVES
EQUIVALENT ANNUAL ANNUITY
Project G Project H
PV = $6.38 PV = $6.12
N=4 N=3
I = 5% I = 5%
Solve for PMT Solve for PMT

PMT = $1.80 PMT = $2.25

Therefore, Project H is preferred (higher equivalent annual annuity).

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 DECISION MAKING UNDER
CAPITAL RATIONING
• When there is capital rationing, the company may not be able to invest in all
profitable projects.
• The key to decision making under capital rationing is to select those projects
that maximize the total net present value given the limit on the capital budget.
• Capital rationing may result in the rejection of profitable projects.

• TYPES OF RATIONING
• Soft Rationing
- Imposed by management
• Hard Rationing
- Imposed by unavailability of funds in capital market

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 EXAMPLE: CAPITAL RATIONING
• Consider the following projects, all with a required rate of return of 4%:
Initial
Project Outlay NPV PI IRR
One –$100 $20 1.20 15%
Two –$300 $30 1.10 10%
Three –$400 $40 1.10 8%
Four –$500 $45 1.09 5%
Five –$200 $15 1.08 5%

Which projects, if any, should be selected if the capital budget is:

1. $100?
2. $200?
3. $300?
4. $400?
5. $500?

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 EXAMPLE: CAPITAL RATIONING
Possible decisions:

Budget Choices NPV Choices NPV Choices NPV

$100 One $20
$200 One $20 Five $15
$300 One + Five $35 Two $30
$400 One + Two $50 Three $40
$500 One + Three $60 Four $45 Two + Five $45

Optimal choices

Key: Maximize the total net present value for any given budget.

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 RISK ANALYSIS: STAND-ALONE METHODS
• Sensitivity analysis involves examining the effect on NPV of changes in one
input variable at a time.
• Scenario analysis involves examining the effect on NPV of a set of changes
that reflect a scenario (e.g., recession, normal, or boom economic
environments).

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RISK ANALYSIS: MARKET RISK METHODS
The required rate of return, when using a market risk method, is the return that a
diversified investor would require for the project’s risk.
- Therefore, the required rate of return is a risk-adjusted rate.
- We can use models, such as the CAPM or the arbitrage pricing theory, to
estimate the required return.
Using CAPM,
ri = RF + βi [E(RM) – RF] (10)
where
ri = required return for project or asset i
RF = risk-free rate of return
βi = beta of project or asset i
[E(RM) – RF] = market risk premium, the difference between the expected
market return and the risk-free rate of return

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Thank you

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