Investment Appraisals

(Capital Budgeting)

Lecture 5

Tawhid A. Chowdhury
Assistant Professor (Finance)
Dept. of Business Administration
 The NPV Decision Rule
• The net present value (NPV) of a project or
investment is the difference between the
present value of its benefits and thepresent
value of its costs.
– Net Present Value

NPV  PV (Benefits)  PV (Costs)

NPV  PV (All project cash flows)

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 The NPVDecisionRule
• When making an investment decision, take
the alternative with the highestNPV.Choosing
this alternative is equivalent to receiving its
NPV in cashtoday.

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 The NPVDecision Rule(cont'd)
• Accepting or Rejecting aProject
– Accept those projects with positive NPV because
accepting them is equivalent to receiving their
NPV in cashtoday.
– Reject those projects with negative NPV because
accepting them would reduce the wealth of
investors.

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Example 3
• Assume that the risk-free interest rate is 10%.
Rank each of the four projects from most
desirable to least desirable based upon NPV.
Which project would you invest in first? Are
there any projects that you wouldn't invest in?
Cash flow
Project Cash flow today in oneyear
"alpha" -18 23
"beta" 15 -12
"gamma" 15 -20
"delta" -16 21
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Answer 3
• Solution:

1. NPV beta = 15 - 12 / 1.1 = 4.09

2. NPV delta = -16 + 21 / 1.1 = 3.09
3. NPV alpha = -18 + 23 / 1.1 = 2.91
4. NPV gamma = 15 - 20 / 1.1 = -3.18

• Would never invest in gamma.

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 Calculating the Net PresentValue
• Calculating the NPV of future cash flows
allows us to evaluate an investmentdecision.
• Net Present Value compares the present value
of cash inflows (benefits) to the present value
of cashoutflows (costs).

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 Example5
• Problem
– Would you be willing to pay $5,000 for the
following stream of cash flows if thediscount rate
is 7%?
0 1 2 3

$3,000 $2,000 $1,000

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 Answer5
• Solution
– The present value of the benefits is:
3000 / (1.07) + 2000 / (1.07)2 + 1000 / (1.07)3 = 5366.91

– The present value of the cost is $5,000, becauseit

occurs now.
– The NPV = PV(benefits) – PV(cost)
= 5366.91 – 5000 = 366.91

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 Perpetuities
• When a constant cash flow will occurat
regular intervals forever it is called a
perpetuity.
0 1 2 3 4 5 …… ∞
C C C C C …… ∞

C C C C C
PV Perpetuity  1
 2
 3
 4
 5
 ......
(1 r) (1 r) (1 r) (1 r) (1 r)

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Short Cuts
Perpetuity - Financial concept in which a cash flow is
theoretically received forever.

cash flow
Return 
present value
C C
r  PV 
PV r
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 Cash Flows
Example –
Consider the following new project:-
Initial capital investment of £15m.
It will generate sales for 5 years.
Variable Costs equal 70% of sales.
Fixed cost of project =£200,000 P.A.
A feasibility study, cost £5000, has already been carried out.
Discount rate = 12%.
Should we take the project?

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Cash Flows
£000's 20X0 20X1 20X2 20X3 20X4 20X5

SALES 14000 16000 18000 20000 22000 90000

VARIABLE COSTS -9800 -11200 -12600 -14000 -15400 -63000

OPERATING EXPENSES -200 -200 -200 -200 -200 -1000

EQUIPMENT COSTS -15000 -15000

CASHFLOWS -15000 4000 4600 5200 5800 6400 11000

DF @ 12% 1.00 0.893 0.797 0.712 0.636 0.567

NPV -15000 3571 3667 3701 3686 3632 3257

19.75% 1.00 0.84 0.70 0.58 0.49 0.41

IRR = 19.75% -15000 3340 3208 3028 2820 2599 -4

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 Cash Flows
Treatment of depreciation in NPV analysis.
-We only use cashflows in investment appraisal.
-Depreciation is not a cashflow. Depreciation is an accounting method of allocating the
cost of a tangible asset over its useful life.
-However, depreciation (capital allowances) is allowable against tax (see income
statement), which affects cashflow.
For cashflow, add depreciation back:-

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Treatment of Depreciation
Tax rate =20%

£000's 2000 2001 2002 2003 2004 2005

SALES 14000 16000 18000 20000 22000 90000

VARIABLE COSTS -9800 -11200 -12600 -14000 -15400 -63000

OPERATING EXPENSES -200 -200 -200 -200 -200 -1000

EQUIPMENT COSTS 0
DEPRECIATION -3000 -3000 -3000 -3000 -3000
NOI 0 1000 1600 2200 2800 3400 11000
NOI AFTER TAX NOI-TAX 800 1280 1760 2240 2720 8800
ADD BACK DEPN (= NCF) 3800 4280 4760 5240 5720 23800

DF @ 12% 1.00 0.893 0.797 0.712 0.636 0.567

-15000 3393 3412 3388 3330 3246 1769

NPV -15000 3266 3162 3022 2859 2683 -8

DF% 16.35 1.00 0.86 0.74 0.63 0.55 0.47

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Issues to Consider
Cash Flows
• Cash flows should be incremental
- include all incidental effects (redundancy)
- Do not forget working capital
- Do forget sunk costs!
- Be careful with allocated overheads

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 NPVand IRR
• Consider a take-it-or-leave-it investment
decision involving a single, stand-alone project
for Fredrick’s Feed and Farm(FFF).
– The project costs $250 million and is expected to
generate cash flows of $35 million per year,
starting at the end of the first year and lasting
forever.

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 NPVRule
• The NPV of the project is calculatedas:

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NPV   250 
r

• The NPV is dependent on the discount rate.

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 Figure 1: NPVof Fredrick’s FertilizerProject

• If FFF’scost of capital is 10%, the NPV is $100 million and they should undertake the
investment.
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 The Internal Rate of ReturnRule
• Internal Rate of Return (IRR) InvestmentRule
– Take any investment where the IRR exceeds the
cost of capital. Turn down any investmentwhose
IRR is less thanthe cost of capital.

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 The Payback Rule
• The payback period is amount of time it takes
torecover or pay back the initial investment. If
the payback period is less than a pre-specified
length of time, you accept the project.
Otherwise, you reject theproject.
– The payback rule is used by many companies
because of its simplicity.

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 PAYBACK

Project A Project B
Yr 0 - 1,000,000 - 1,000,000
Yr 1 + 1,100,000 + 500,000
Yr 2 + 200,000 + 500,000
Yr 3 - 100,000 + 500,000

Project A = Year .909

Project B = ?
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 Example9
• Problem
– Projects A, B, and Ceach have an expected life
of 5 years.
– Given the initial cost and annual cash flow
information below, what is the paybackperiod
for each project?
A B C
Cost $80 $120 $150
Cash Flow $25 $30 $35

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 Answer 9
• Solution
– Payback A
• $80 ÷ $25 = 3.2years

– Project B
• $120 ÷ $30 = 4.0 years

– Project C
• $150 ÷ $35 = 4.29years

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Discounted Payback
• The discounted payback period is the amount of time that it takes to cover
the cost of a project, by adding positive discounted cash flow coming from
the profits of the project.

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Example 10
• An initial investment of $2,324,000 is expected to generate $600,000 per
year for 6 years. Calculate the discounted payback period of the investment if
the discount rate is 11%.

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Answer 10
• Step 1: Prepare a table to calculate discounted cash flow of each period by
multiplying the actual cash flows by present value factor. Create a cumulative
discounted cash flow column.
Year CashFlow Present Value Factor Discounted CashFlow Cumulative Discounted
n CF PV$1=1/(1+r)n CF×PV$1 CashFlow
0 $ −2,324,000 1 $ −2,324,000 $ −2,324,000
1 600,000 0.9009 540,541 −1,783,459
2 600,000 0.8116 486,973 −1,296,486
3 600,000 0.7312 438,715 − 857,771
4 600,000 0.6587 395,239 − 462,533
5 600,000 0.5935 356,071 − 106,462
6 600,000 0.5346 320,785 214,323

• Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32 years

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Accounting Rate of Return
Accounting Rate of Return - Average income divided by
average book value over project life. Also called
book rate of return.

Accounting rate of return  accounting average income

initial investment

Managers rarely use this measurement to make

decisions. The components reflect tax and
accounting figures, not market values or cash flows.

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 Example 11
• Problem
• – An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for
6 years. Depreciation is allowed on the straight line basis. It is estimated that the project will
generate scrap value of $10,500 at end of the 6th year.Calculate its accounting rate of return
assuming that there are no other expenses on the project.

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Answer 11
• Annual Depreciation = (Initial Investment − Scrap Value)
÷ Useful Life in Years
– Annual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917
• Average Accounting Income = $32,000 − $19,917 =
$12,083
• Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%

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 Selection Methods
• Payback

• Accounting Rate of Return

• Net Present Value (NPV)

• Internal Rate of Return (IRR)

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Selection Methods
• Every possible method for evaluating projects
impacts the flow of cash about the company as
follows.
Cash

Investment Investment projects

opportunity Financial Shareholders (financial assets)
(real asset) Manager

Invest Alternative: Shareholdersinvest

pay dividend for themselves
to shareholders
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 IDEAL Selection Method
Will
• Select the project that maximises shareholders wealth
• Consider all cash flows
• Discount the cash flows at the appropriate market determined opportunity
cost of capital
• Will allow managers to consider each project independently from all others

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Think!
• What are the benefits and drawbacks of each selection method?

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 CFODecisionTools
Survey Data on CFO Use of Investment Evaluation Techniques

SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal
of Financial Economics 61 (2001), pp. 187-243.
 NPV vs IRR
1. NPV accepts all projects with NPV > 0.
Ranking of projects is by value of NPV.
2. IRR finds the value of the discount rate that
makes NPV = 0. Project will be accepted if
IRR > k (cost of capital)
The big Q?
Will the two methods always give the same
answer?
No, unfortunately not

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 The Internal Rate of ReturnRule
(cont'd)
• In general, the IRRrule works for a stand-
alone project if all of the project’snegative
cash flows precede its positive cashflows.
– In Figure 1, whenever the cost of capital is below
the IRR of 14%, the project has a positive NPV and
you should undertake the investment.

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 Applying The IRRRule
• In other cases, the IRRrule may disagreewith
the NPV rule and thus be incorrect.
– Situations where the IRR rule and NPV rule may be
in conflict:
• Delayed Investments
• Multiple IRRs
• Nonexistent IRR

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 Applying The IRRRule(cont'd)
• Delayed Investments
– Assume you have just retired as the CEOof a successful
company. A major publisher has offered you a book deal.
The publisher will pay you $1 million upfront if you agree
to write a book about your experiences. You estimatethat
it will take three years to write the book. The time you
spend writing will cause you to give up speaking
engagements amounting to $500,000 per year. You
estimate your opportunity cost tobe 10%.

1m -0.5m -0.5m -0.5m

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 Applying The IRRRule(cont'd)
• Delayed Investments
– Should you accept the deal?

500, 000 500, 000 500, 000

NPV  1,000,000   2
 3
  $243,426
1.1 1.1 1.1

– Since the NPV is negative, the NPV rule indicates

you should reject the deal.

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 Applying The IRRRule(cont'd)
• Delayed Investments
– Should you accept the deal?
• Calculate the IRR=23.38%.

23.38%

– The IRR is greater than the cost of capital. Thus,

the IRR rule indicates you should accept the deal.

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 NPVof Star’s $1 Million BookDeal

• When the benefits of an investment occur before the costs, the NPV is anincreasing
function of the discountrate.
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 Applying The IRRRule(cont'd)
• Multiple IRRs
– Suppose Star informs the publisher that it needs
to sweeten the deal before he will accept it. The
publisher offers $550,000 advance and
$1,000,000 in four years when the bookis
published.
– Should he accept or reject the newoffer?

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 Applying The IRRRule(cont'd)
• Multiple IRRs
– The cash flows would now look like:

– The NPV is calculated as:

 550,000 - 500, 000 - 500,000 - 500,000  1,000,000

NPV
1  r (1  r) 2 (1  r) 3 (1  r) 4

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 Applying The IRRRule(cont'd)

• Multiple IRRs
– By setting the NPV equal to zero and solving for r,
we find the IRR. In this case, there are two IRRs:
7.164% and 33.673%. Because there is more than
one IRR, the IRR rule cannot beapplied.
– Given r=10%, NPV =-10,412.54

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NPVof Star’s Book Deal withRoyalties

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 Applying The IRRRule(cont'd)
• Nonexistent IRR
– Finally, Star is able to get the publisher to increase
his advance to $750,000, in addition to the $1
million when the book is published in four years.
With these cash flows, no IRR exists; there is no
discount rate that makes NPV equal to zero.

 - 500, 000 - 500, 000 - 500,000  1,000,000

NPV 750,000
550,000
1  r (1  r) 2 (1  r) 3 (1  r) 4

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NPVof Star’s Final Offer

Given r= 10%, NPV=185,987.46

• No IRRexists because the NPV is positive for all values of the discount rate. Thus the
IRRrule cannot beused.
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 Choosing Between Projects
• Mutually ExclusiveProjects
– NPVRule
• Select the project with the highestNPV.

– IRRRule
• Selecting the project with the highest IRR may
lead to mistakes (even the negative cash flows
precede the positive cash flows)

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Reinvestment Rate Assumption

Project Yr0 Yr1 Yr2 Yr3 C of K NPV IRR

X -10,000 5,000 5,000 5,000 10% 2,430 23.4%
Y -10,000 0 0 17,280 10% 2,977 20.0%

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NPV Vs IRR
Relationship between NPV,IRR and Discount Rates

0 10 20 30 40 Disc rate

NPV

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Value Additivity

Project NPV @10% IRR%

1 354 134.5
2 104 125.0
3 309 350.0

1+3 663 212.8

2+3 413 237.5

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Self-test questions
• Does the NPV decision rule depend on the investor’s
preferences?
• Can you compare or combine cash flows at different
times?
• Can you explain the discounted cash flow (DCF) method
of valuing a project?
• What are NPV, IRR, payback and ARR rules? Which one
is the best out of the four methods and why?

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