3.

DISCOUNTED CASH FLOW - TECHNIQUES

1. Capital Investment Monitoring
 Capital investment projects are an important mechanism for creating wealth for shareholders, but
they also expose a company to significant risk.
 A capital project is a long-term investment normally in tangible assets.
 The principles and tools of capital investment are applied in many different aspects of a business
entity’s decision making and in security valuation and portfolio management.
 A company’s capital investment process and prowess are important in valuing a company.

Control Process

1. Creating an This may involve using suggestion schemes,

creating innovation targets, benchmarking.
environment encouraging
innovation

2. Preliminary screening To remove ideas that do not fit with the company's
strategy and resources (SWOT)

3. Financial analysis Detailed investigation of risk and return

4. Authorisation At central or divisional level, depending on the size

of the project.

5. Monitoring and review Compare expected and realized results and explain
any deviations

Project Classification

Replacement New Products and

Expansion Projects
Projects Services

Regulatory, Safety,
and Environmental Other
Projects

2. Basic Principles of Investment Appraisal

Costs: include or exclude?
 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.

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  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. Eg: cannibalization.

- Cannibalization is an externality in which the investment reduces cash flows elsewhere in the
company (e.g., takes sales from an existing company project).

3. Investment Decision Tools

Net Present Value (NPV)

Internal Rate of Return (IRR)
Payback Period
Discounted Payback Period
Return on Capital Employed(ROCE/AAR)
Profitability Index (PI)

In AFM, we shall focus more on following tools:

DISCOUNTED CASH FLOW TECHNIQUES - 2

Investment Decision under Risk and Uncertainty

3.1. Capital Investment- NPV

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

If NPV > 0:
• Invest: Capital project adds wealth

If NPV < 0:
• Do not invest: Capital project destroys wealth

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Consider the Project with following cash flow with 9% discount rate:

Period Cash Flow (millions)

0 –Rs.1,000
1 200
2 300
3 400
4 500

Rs. 200 Rs. 300 Rs. 400 Rs. 500

NPV = – Rs. 1,000 + + + +
1 + 0.09 1 + 0.09 1 + 0.09 1 + 0.09

NPV = −Rs. 1,000 + Rs. 183.49 + Rs. 252.50 + Rs. 308.87 + Rs. 354.21
NPV = Rs.99.08 million

Decision:
Since at 9% cost of capital, the NPV of the project is positive, it means the project will add shareholders
wealth so it shall be accepted.

Impact of tax:
 Corporation tax can have two impacts on NPV calculations in the exam:
1. Tax will need to be paid on profit on the cash.
2. Tax will be saved if tax allowable depreciation (TAD) can be claimed.
 Add back of TAD is required it is not in itself a cash flow.

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  In the final year a balancing allowance or charge will be claimed to reduce the written down
value of asset to zero (after accounting for any scrap value).
 The timing and rates of tax, and of tax allowable depreciation will be given in an exam question.

Impact of Inflation:
 Inflation is a feature of all economies and must be accommodated in financial planning.
 Real Cash flows (cash flows in current prices) should be discounted at real discount rate, which
is return ignoring inflation.
 Nominal cash flows (the actual expected cash flows at future prices) should be discounted at a
nominal rate which is rate relating to current markets rates of returns.
 Issue: Although the nominal required rate of return reflects inflation expectations and sales and
operating expenses are affected by inflation,
- The effect of inflation may not be the same for sales as operating expenses.
- Depreciation is not affected by inflation.
 The relationship between real and nominal rates of interest is given by the Fisher Formula.
(1+m) = (1+r) (1+i)
Where, m = money rate or nominal rate
r = real interest rate
i = general rate of inflation
PP: Avanti Co is considering a major investment programme which will involve the creation of a chain
of retail outlets. The following cash flows are expected.

a) 60% of office overhead is an allocation of head office operating costs.

b) The cost of land and buildings includes $80,000 which has been spent on surveyors' fees.
c) Avanti Co expects to be able to sell the chain at the end of Year 4 for $4,000,000.
Avanti Co is paying corporate tax at 30% and is expected to do so for the foreseeable future. Tax is paid
one year in arrears. Tax allowable depreciation is available on fittings and equipment at 25% on a
reducing balance basis, any unused tax allowable depreciation can be carried forward.
Estimated resale proceeds of $100,000 for the fittings and equipment have been included in the total
figure of $4,000,000 given above.
Avanti Co expects the working capital requirements to be 14.42% of revenue during each of the four
years of the investment programme.
Avanti's real cost of capital is 7.7% p.a.
Inflation at 4% p.a. has been ignored in the above information. This inflation will not apply to the resale
value of the business which is given in nominal terms.
Required
Complete the shaded areas in the partially completed solution to calculate the NPV for Avanti's
proposed investment.

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3.2. 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.
∑ − Outlay = 0
( )
Or, reflecting the outlay as CF0,
∑ = 0
( )
where
CFt = After-tax Operating cash flow at time t
r = Required rate of return for the investment (WACC)
Outlay = Investment cash flow at time zero

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.

If IRR > r (required rate of return):

• Invest: Capital project adds value
If IRR < r:
• Do not invest: Capital project destroys value

Consider the earlier Project:

Cash Flow
Period (millions)
0 –Rs.1,000
1 200
2 300
3 400
4 500

NPV at 9% DF= Rs.99.08 million

Rs. 200 Rs. 300 Rs. 400 Rs. 500
NPV = – Rs. 1,000 + + + +
1 + 0.13 1 + 0.13 1 + 0.13 1 + 0.13

NPV = (Rs.4.19 million)

Solution:
By interpolation

IRR = LR + x(HR − LR)

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 .
= 9% + x(13% − 9%)
. ( . ))

= 12.84%

IRR from spreadsheet will be calculated as:

= IRR (values, guess) = 12.8257%

𝑫𝒆𝒄𝒊𝒔𝒊𝒐𝒏:
Since at IRR of the project is 12.84%, which is higher than cost of capital, project will add shareholders
wealth so it shall be accepted.

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

Which is Superior NPV vs. IRR?

NPV is superior to IRR due to following reasons:
i. NPV is absolute measures where IRR is relative measure.
ii. Re-investment rate of NPV is assumed to be in cost of capital rate which is more justifiable but IRR
assumes re-investment rate of intermediate cash flow at IRR rate which is more illogical and may
not be practicable over project life.

iii. IRR decision criteria will be more confusing when encountered with multiple IRR (in case of non-
conventional cash flow) but NPV decision criteria can always be considered well even in case of
non-conventional cash flow.

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IRR assumes re-investment rate of intermediate cash flow at IRR rate which is more illogical and may not
be practicable over project life.

Each cash flow generated from year 1 to year 5 is re-invested at 18% (IRR rate) to give terminal value of
228,775.78.
As we know, FV = PV x (1+r)n Cash flow redrawan to:
𝑭𝑽 1/n
𝒓= -1 Years CF
𝑷𝑽
0 (100,000.00)
Replacing above formula we derive IRR formula as: 1 -

2 -
𝑻𝒆𝒓𝒏𝒎𝒊𝒏𝒂𝒍 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 𝒑𝒉𝒂𝒔𝒆 1/n
𝑰𝑹𝑹 = -1 3 -
𝑷𝑽 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒑𝒉𝒂𝒔𝒆
4 -

𝟐𝟐𝟖,𝟕𝟕𝟓.𝟕𝟖 1/5 5 228,775.78

𝑰𝑹𝑹 = -1 = 18%
𝟏𝟎𝟎,𝟎𝟎𝟎.𝟎𝟎 IRR 18.00%

DISCOUNTED CASH FLOW TECHNIQUES - 8

Why Modified Internal Rate of Return (MIRR)
Modified internal rate of return is a calculation of the return from a project, as a percentage yield, where
it is assumed that cash flows earned from a project will be reinvested to earn a return equal to the
company’s cost of capital.
Now we can simply take our new set of cash
flows and solve for the IRR, which in this
case is actually the MIRR

Each cash flow generated from year 1 to year 5 is re-

invested at 10% (COC rate) to give terminal value of
209,892.

IRR formula is substituted as MIRR:

𝑻𝒆𝒓𝒏𝒎𝒊𝒏𝒂𝒍 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 𝒑𝒉𝒂𝒔𝒆 1/n
𝑴𝑰𝑹𝑹 = -1
𝑷𝑽 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒑𝒉𝒂𝒔𝒆

𝟐𝟎𝟗,𝟖𝟗𝟐 1/5
𝑴𝑰𝑹𝑹 = -1 = 15.98%
𝟏𝟎𝟎,𝟎𝟎𝟎

In Spreadsheet
=MIRR(values, finance_rate, reinvest_rate)
=MIRR(Values_range, 10%,10%)

Alternative method - MIRR

Step 1:
Calculate the total PV of the cash flows (A) involved in the investment phase of the project.
Do this by taking the negative net cash flows in the early years of the project, and discount these to a
present value.

Step 2:
Take the PV cash flows (B) from the year that the project cash flows start giving return.

Step 3:
The MIRR is then calculated as follows:
𝑴𝑰𝑹𝑹 = [𝑩/𝑨]1/n x(1+r) -1
𝑷𝑽 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 𝒑𝒉𝒂𝒔𝒆 1/n
𝑴𝑰𝑹𝑹 = x (1+r) -1
𝑷𝑽 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒑𝒉𝒂𝒔𝒆

DISCOUNTED CASH FLOW TECHNIQUES - 9

Where, r = cost of capital
Years CF DF@10% (COC) PV of Cash Outflow (Investment) PV of Cash Inflow (Return)

0 (100,000.00) 1.000 (100,000.00)

1 18,000.00 0.909 16,363.64

2 18,000.00 0.826 14,876.03

3 18,000.00 0.751 13,523.67

4 18,000.00 0.683 12,294.24

5 118,000.00 0.621 73,268.72

IRR 18.00% (100,000.00) 130,326.29

𝟏𝟑𝟎,𝟑𝟐𝟔.𝟐𝟗 1/5
𝑴𝑰𝑹𝑹 = x (1+0.1)-1 = 15.98%
𝟏𝟎𝟎,𝟎𝟎𝟎

Calculate MIRR of the cash flow given in PP 1 and PP 2.

Practice Problem 1 Practice Problem 2
Years CF Years CF
0 (20,000.00) - (100,000.00)
1.00 18,000.00
1.00 (2,000.00)
2.00 (50,000.00)
2.00 12,000.00
3.00 25,000.00
3.00 14,000.00 4.00 25,000.00
4.00 12,000.00 5.00 225,000.00
Hints: 17.73% Hints: 16.94%

MIRR for Two different rates – re-investment rate and financing rate
One other feature of the MIRR is that it can be calculated even if the firm's depositing (re-investment rate)
and borrowing rates (financing rate) of interest are different. In this case, the calculation has to be adapted
as follows:

Method
1) Find the terminal value of the cash inflows from the project if invested at the company's
reinvestment rate.
2) Find the present value of the cash outflows, discounted at the company's cost of finance.
3) The MIRR is then found by taking the nth root of (TV inflows/PV outflows) and subtracting 1.
𝑻𝑽 𝒐𝒇 𝒊𝒏𝒇𝒍𝒐𝒘𝒔 1/n
𝑴𝑰𝑹𝑹 = -1
𝑷𝑽 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔

DISCOUNTED CASH FLOW TECHNIQUES - 10

 PP 3: The firm's Years CF
financing rate (for
negative cash - (20,000.00)
flows) is 9%, and its 1.00 4,000.00
reinvestment rate 2.00 (2,000.00)
for positive cash
flows is 6% with
3.00 6,000.00
following cash 4.00 7,600.00
flows. Calculate 5.00 10,000.00
MIRR.

Solution:
TV of PV of re-
Year return Investment
Rate 6% 9%
0 (20,000) (20,000)/(1+0.09)^0
1 5,050 4,000*(1+0.06)^4
2 (1,683) (2,000)/(1+0.09)^2
3 6,742 6,000*(1+0.06)^2
4 8,056 7600*(1+0.06)^1
5 10,000 10,000*(1+0.06)^0
29,848 (21,683)
𝟐𝟗,𝟖𝟒𝟖 1/5
𝑴𝑰𝑹𝑹 = -1
𝟐𝟏,𝟔𝟖𝟑
=6.60%
Conclusion: The extent to which the MIRR exceeds the cost of capital is a new project is generating value.
Although MIRR, like IRR, cannot replace net present value as the principal evaluation technique it does
give the maximum cost of finance that allow the project to remain worthwhile.

Decision under Risk and Uncertainty

3.3. Payback Period (PBP)
When Cash inflows are When Cash inflows are not When Cash inflows are not equal but
equal equal but cumulative CF is cumulative CF starts as positive from negative.
zero at some point
Years CF Years CF Cumm CF Years CF Years CF Cumm CF
0 (1,000.00) 0 (1,000.00) (1,000.00) 0 (1,000.00) 0 (1,000.00) (1,000.00)
1 400.00 1 200.00 (800.00) 1 300.00 1 300.00 (700.00)
2 400.00 2 300.00 (500.00) 2 500.00 2 500.00 (200.00)
3 400.00 3 500.00 - 3 500.00 3 500.00 300.00
4 500.00 500.00 4 300.00 4 300.00 600.00
4 400.00

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 PBP = Investment / PBP = Year when PBP = Year when cumulative CF is last time
Equal Annual CF cumulative CF is zero negative + Last Uncovered negative CF/CF of
= 1000/400 = 3 years succeeding year
= 2.5 years = (2 + 200/500) years
= 2.40 Years
Problem: Ignores timing of cash flows within the payback period and also the cash flows that arise after
the payback period.

3.4. Discounted Payback Period (DPBP)

Discounted Payback Period (PBP) – same as PBP but accounts for time value of money
Consider two projects X and Y PV of Cash flows (DCF) Cumulative DCF
Years X Y DF @10% DCF X DCF Y Cumm DCF X Cumm DCF Y
0 (1,000.00) (1,000.00) 1 (1,000.00) (1,000.00) (1,000.00) (1,000.00)
1 181.82 454.55 (818.18) (545.45)
1 200.00 500.00
1 413.22 247.93 (404.96) (297.52)
2 500.00 300.00 1 225.39 525.92 (179.56) 228.40
3 300.00 700.00 1 614.71 136.60 435.15 365.00
4 900.00 200.00 NPV 435.15 365.00
Discounted PBP = Year when cumulative DCF is last time negative
+
Last Uncovered negative DCF/DCF of succeeding year

X Y
PBP = (3 + 179.56/614.71) years (2 + 297.52/525.92) years
= 3.29 Years = 2.57 Years

 A better method since it adjusts for time value.

 Problem: The cash flows that arise after the payback period is ignored again.

3.5. Expected Values (Probability Analysis)

 Using probabilities to calculate average expected NPV. Probabilities may be highly subjective.
 If the outcome from an investment is uncertain, but the probability associated with each of the
possible outcomes is known, an expected value calculation can be used.
 The expected value is calculated as the sum of (each outcome multiplied by its associated
probability).
 Although the calculation gives a useful long-run average figure, it is not useful for one-off
calculations.
PP 4: DD plc is considering launching a new product.
This will require additional capital investment of $200,000.
The selling price of the product will e $10 p.u.. DD has ascertained that the probability of a demand
of 50,000 units p.a. is 0.5, with a probability of 0.4 that it will be 20% higher, and a 0.1 probability
that it will be 20% lower.
The company expects to earn a contribution of 50% and expects fixed overheads to increase by
$140,000 per year.

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 The time horizon for appraisal is 4 years. The machine will be sold at the end of 4 years for $50,000.
The cost of capital is 20% p.a.
(a) Calculate the expected NPV of the project
(b) Assuming that the demand is certain at 50,000 units p.a. what is the NPV of the project if
fixed overheads are uncertain as follows:
Fixed overheads Probability
100,000 0.20
140,000 0.35
180,000 0.25
220,000 0.20

Expected Values – Conditional Probability

 Since one event may depend upon another, we may get situations where event one has a certain
probability of occurring and event two, which depends on event one occurring, has another
probability of occurring.
 In such circumstances, we have a situation of combined probabilities.
 For example, if event one has a 0.6 chance of occurring and subsequent event two a 0.75 chance
of occurring, then overall the probability of both events occurring is:
0.6 x 0.75 = 0.45
i.e. a 45% chance of occurring.
 Problems where one or more decisions have to be taken can become more complex and may
require the use of a decision tree, with expected values being used to evaluate each of the
decisions.
PP 5: A company is considering a project involving the outlay of $300,000 which it estimates will
generate cash flows over its two-year life at the probabilities shown in the following table. Cash flows
for project are:
Year 1
Cash flow$ Probability
100,000 0.25
200,000 0.50
300,000 0.25
Year 2

If cash flow in that the cash flow in 2nd year CF with

Year 1 is: Year 2 will be: probability of:

100,000.00 100,000.00 0.50

200,000.00 0.50

200,000.00 100,000.00 0.75

300,000.00 0.25

300,000.00 200,000.00 0.25

300,000.00 0.75
The company's cost of capital for this type of project is 10% DCF.

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 You are required to calculate the expected value (EV) of the project's NPV and the probability that the
NPV will be negative.

3.6. Sensitivity Analysis

Sensitivity Analysis in Capital Investment
Sensitivity analysis typically involves posing ‘what if?’ questions.
 For example, what if demand fell by 10% compared to our original forecasts? Would the project
still be viable?
 Ideally we want to know how much demand could fall before the project should be rejected or,
equivalently, the breakeven demand that gives an NPV of zero. We could then assess the
likelihood of forecast demand being that low.

Calculating sensitivity
This maximum possible change is often expressed as a percentage:
Sensitivity margin = NPV/PV of flow under consideration*100%
PP 6: An investment of $40,000 today is expected to give rise to annual contribution of $25,000. This is
based on selling one product, with a sales volume of 10,000 units, selling price of $12.50 and variable
costs per unit of $10. Annual fixed cost of $10,000 will be incurred for the next four years; the discount
rate is 10%.
Required:
(a) Calculate the NPV of this investment.
(b) Calculate the sensitivity of your calculation to the following:
(i) initial investment
(ii) selling price per unit
(iii) variable cost per unit
(iv) sales volume
(v) fixed costs
(vi) discount rate
Hints: (a) NPV = $7,550; (b) (i) 18.9%; (ii) 1.9%; (iii) 2.4%; (iv) 9.5%; (v) 23.8%; (vi) 84.5% (IRR = 18%)

3.7. Simulation
Simulation is a technique which allows more than one variable to change at the same time.
You will not be required in the examination to actually perform a simulation, but you should be aware
of the principle involved. Essentially, the stages are as follows:
 identify the major variables
 specify the relationship between the variables
 attach probability distributions to each variable and assign random numbers to reflect the
distribution
 simulate the environment by generating random numbers
 record the outcome of each simulation
 repeat the simulation many times to be able to obtain a probability distribution of the possible
outcomes
Simulation analysis (Monte Carlo analysis) involves examining the effect on NPV when all uncertain
inputs follow their respective probability distributions.
- With a large number of simulations, we can determine the distribution of NPVs.

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 PP 7: Simulation

3.8. Project Duration

 Project duration: a measure of the average time over which a project delivers its value.
 Project duration shows the reliance of a project on its later cash flows, which are less certain than
earlier cash flows (it does this by weighting each year of the project by the % of the present value
of the cash inflows received in that year)
 Duration captures both
 the time value of money and
 the whole of the cash flows of a project (unlike PBP or DPBP)
 Projects with higher durations carry more risk than projects with lower durations.
 Project duration is also known as Macaulay Duration.

 Both the projects have equal NPV so results in indifferent decision.

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  Project B is safer under DPBP (2.80 years against 3.57 years) but project B has failed to address
cash flow of year 4.
 Project B is less risky under Project Duration (2.71 years against 4 years) because project B has
delivered its value sooner than project A. Also, Project Duration has considered both time value
of money and cash flows over the project.

What is a project duration?

 Duration measures either the weighted average time
 to recover the initial investment (if discounted at the project’s internal rate of return) of
a project, or
 to recover the present value of the project if discounted at the cost of capital.
Sum of the (Product of PV of inflows and )
 𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
Sum of PV of Inflows
Project A

PV of Cash
Year 0 1 2 3 4 Inflows NPV
PV of CF (CF x DF @10%) (2,000) - - 3,500 3,500 1,500.00
Duration (Year x PV of CF) 0 0 0 14,000

Project Duration (0+0+0+14,000)/3,500 = 4 years

Project B
PV of Cash
Year 0 1 2 3 4 Inflows NPV
PV of CF (2,000) 800 800 500 1,400 3,500 1,500.00
Duration (Year x PV of CF) 800 1,600 1,500 5,600

Project Duration (800+1,600+1,500+5,600)/3,500 = 2.71 years

Modified Duration is the name given to the price sensitivity and is the percentage change in price for a
unit change in yield/cost.
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
1+cost of capital
Modified Duration of Project B = 2.71/(1+0.1) = 2.46 years
PV of Cash
Year 0 1 2 3 4 Inflows NPV
CF (2,000) 880 968 666 2,050
DF @11% 1.000 0.901 0.812 0.731 0.659
PV of CF (2,000) 793 786 487 1,350 3,415.28 1,415.28
Duration (Year x PV of CF) 793 1,571 1,460 5,401
Change in price of Project by unit change in cost of capital
= 3,415.28 - 3,500 = $84.72
% Change in price of Project by unit change in cost of capital
= $84.72/$3,500 = 2.42% approx. equal to modified duration

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3.9. Value at Risk
 Value at risk (VaR) is a measure of how the market value of an asset or of a portfolio of assets is
likely to decrease over a certain time, the holding period (usually one to ten days), under ‘normal’
market conditions.
 It is typically used by security houses or investment banks to measure the market risk of their
asset portfolios.
 VaR = amount at risk to be lost
 from an investment under usual conditions
 over a given holding period,
 at a particular 'confidence level'.
 Confidence levels are usually set at 95% or 99%, e.g. for a 95% confidence level, the VaR will give
the amount that has a 5% chance of being lost.

 VaR is measured by using normal distribution theory.

Normal distribution, also known as the Gaussian distribution, is a probability distribution that is
symmetric about the mean, showing that data near the mean are more frequent in occurrence
than data far from the mean.
 Approximately 68% of the data falls within one standard deviation of the mean. (μ – σ and μ
+ σ)
 Approximately 95% of the data falls within two standard deviations of the mean. (μ – 2σ and
μ + 2σ)
 Approximately 99.7% of the data fall within three standard deviations of the mean. (μ – 3σ
and μ + 3σ)

Properties of Normal Distribution

 In a normal distribution, the mean, median and mode are equal.(i.e., Mean = Median=
Mode).
 The total area under the curve should be equal to 1.
 The normally distributed curve should be symmetric at the centre.
 There should be exactly half of the values are to the right of the centre and exactly half of
the values are to the left of the centre.
 The normal distribution should be defined by the mean(μ) and standard deviation (σ).
Z = (X – μ)/σ

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 The number of standard deviations associated with 5% value at risk can be calculated by looking
for the figure 0.45.
 The figures 0.4495 and 0.4505 are the closest and they represent 1.64 and 1.65 standard
deviations respectively. So, for a figure of 0.45 we can say that half-way between 1.64 and 1.65,
ie 1.645 standard deviations, is the correct answer

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 Value at risk = Z x standard deviation of project x √T
Z = (X – μ)/σ = derived from normal distribution table.

PP 8: A five-year project has an NPV of $1 million. The project’s cash flows are normally distributed and
the annual standard deviation associated with the cash flows is $0.3 million. Company policy is to accept
only those projects where there is at least a 90% certainty that the net present value will be positive.

Required: Calculate the value at risk of the project and advise whether it should be undertaken.

 A 90% confidence level means that we need to find 0.40 (90% – 50%) in the normal distribution
table – this corresponds to (approximately) 1.28 standard deviations.
 Annual value at risk for a 90% confidence level is 1.28 x $0.3 million = $0.384 million.
 The value at risk over five years = $0.384 million x √5 = $0.859 million.
 A five-year value at risk of $0.859 million means that we can be 90% sure that the NPV won’t fall
by more than $0.859 million over the five-year period.
 The expected NPV is $1 million, so we can be 90% sure that the actual NPV will be at least 1m –
0.859m = $0.141 million.
 This is still a positive NPV, so the project should be undertaken.
PP 9: CC plc estimates the expected NPV of a project to be £100 million, with a standard deviation of
£9.7 million.
Required: Establish the value at risk using both a 95% and a 99% confidence level. Hints: £84. and £77.4
PP 10: A simulation has been used to calculate the expected value of a project and is deemed to be
normally distributed with the following results:
Mean = $40,000 (positive)
Standard deviation = $21,000
Calculate the following:
a) The probability that the NPV of the project will be greater than 0. (hint: 97.13%)
b) The probability that the NPV will be greater than $45,000 (hint: 40.52%)

3.10. Capital Rationing

 Shareholder wealth is maximised by taking on positive NPV projects. However, capital is not
always available to allow this to happen.
 In a perfect capital market, there is always finance available - in reality there is not, there are 2
reasons for this:

HARD CAPITAL RATIONING

This is due to external factors such as banks won’t lend any more - why?

Reasons for Hard Capital Rationing

1. Industry wide factor (recession?)
2. Company has no/poor track record
3. Company has too low credit rating
4. Company has no assets to secure the loan
5. Capital in short supply (crowded out by government borrowing)

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 SOFT CAPITAL RATIONING
Company (management) imposes it’s own spending restriction.

Reasons for Soft Capital Rationing

1. Limited management skills in new area
2. Want to limit exposure and focus on profitability of small number of projects
3. The costs of raising the finance relatively high
4. No wish to lose control or reduce EPS by issuing shares
5. Wish to maintain s high interest cover ratio
6. “Internal Capital market” - deliberately restricting funds so competing projects become more
efficient

Divisible Project: This means that a part of a project can be undertaken leading to a partial return
(proportional to the amount invested).

Single period capital rationing describes a situation where the capital available for investment is in limited
supply, but for one time period only (one year only). The limitation in supply is usually at time 0 (now)
with capital freely available in other periods.

Multi-Period Capital Rationing: When there is capital rationing in more than one year, and some or all of
the projects require additional finance in each year.
A different method is needed to identify the combination of projects that will maximise total NPV, where
the projects are divisible.

Linear programming is used to identify the NPV-maximising combination of projects.

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Single Period Capital Rationing – Divisible Projects

Profitability Index (PI) =

The approach is as follows:

 calculate the NPV per $ of initial investment (the profitability index)
 rank the projects in terms of their profitability indexes
 invest as much as possible in the project with the highest profitability index, then go to the project
with the next highest, and so on until the capital available is exhausted.

Problems with the Profitability Index method

 The approach can only be used if projects are divisible.
 The selection criterion is fairly simplistic, taking no account of the overall objectives of the
organization
 The method is of limited use when projects have differing cash flow patterns
 The Profitability Index ignores the absolute size of individual projects.

PP 11: Consider following divisible Solution:

projects with available funds of Projects Investment NPV PI Rank
$100,000. A 40,000.00 20,000.00 0.50 1st
Projects Investment NPV
B 100,000.00 35,000.00 0.35 3rd
A 40,000.00 20,000.00
C 50,000.00 24,000.00 0.48 2nd
B 100,000.00 35,000.00
C 50,000.00 24,000.00 D 60,000.00 18,000.00 0.30 4th
D 60,000.00 18,000.00 E 50,000.00 10,000.00 0.20 5th
E 50,000.00 10,000.00
Investment Plan
Projects Funds Investment NPV
(100,000.00)
A (60,000.00) 40,000.00 20,000.00
C (10,000.00) 50,000.00 24,000.00
B (partial) - 10,000.00 3,500.00
Total 100,000.00 47,500.00

Single Period Capital Rationing – Indivisible Projects

PP 12: Consider following indivisible Solution:
projects with available funds of $1,600,000.
Projects Investment NPV
A 500,000.00 50,000.00 (b) Funds (c) (e). Surplus
B 600,000.00 57,000.00 (a) Projects Available Investment (d) NPV Cash
C 300,000.00 36,000.00 A, B, C, D (1,600,000) 1,800,000 Not possible -
D 400,000.00 50,000.00 A, B, C (1,600,000) 1,400,000 143,000 200,000
A, B, D (1,600,000) 1,500,000 157,000 100,000
A, C, D (1,600,000) 1,200,000 136,000 400,000
B, C, D (1,600,000) 1,300,000 143,000 300,000

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  Combination of all projects not possible due to limited capital.
 There will be four alternatives for combination of three projects (4C3). This will result in surplus of
funds.
 Alternative evaluation for less than 3 combinations not required as fund is sufficient for any 3
combinations of project.
 Optimum investment plan will be A, B, D with $ 1.5 m investment and $157K NPV with surplus
cash of $100k.

In cases where the projects are not divisible there are two circumstances which might apply:
 the surplus cash could be returned to the providers of finance so that no cost is borne by the
company for the un-invested funds; or (need not care about surplus)
 the surplus cash could be invested at a given rate in which case there would be a positive /
negative NPV of the surplus invested funds to take into account.

PP 13: Consider indivisible projects of PP 12 with assumption that surplus funds can only be invested at
6% in Year 0 for one year. Cost of capital is 10%.
(g). PV of (h) NPV of
(f) .FV of Future cash Surplus Cash
(e). Surplus Surplus cash flow [NPV = (g)- Overall
(a) Projects Cash [FV = (e) x 1.06] [PV =(f)/1.1] (e)] NPV
A, B, C, D -
A, B, C 200,000 212,000 192,727 (7,273) 135,727
A, B, D 100,000 106,000 96,364 (3,636) 153,364
A, C, D 400,000 424,000 385,455 (14,545) 121,455
B, C, D 300,000 318,000 289,091 (10,909) 132,091
 Optimum investment plan will be A, B, D with $ 1.6 m investment and $153.36 K NPV with surplus
cash of NIL.

Multi-Period Capital Rationing – Divisible Projects

Linear programming is used to identify the NPV-maximising combination of projects.
 If there are only two projects the linear programme can be solved using a graphical approach in
the usual way.
 If there are more than two projects the simplex technique must be used. (This is not in your
syllabus but need to derive inequalities).

Formulating the linear programming problem

 A linear programming problem is stated as an objective function that is subject to certain
constraints or limitations.
 The objective function is to maximise or minimise something.
 With capital rationing, the objective function should be to maximise the total NPV.

Overall approach
Step 1: Define variables.
Step 2: Construct an objective function
Step 3: Construct inequalities to represent the constraints.
Step 4: Plot the constraints on a graph

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Step 5: Identify the feasible region. This is an area that represents the combinations of projects that are
possible in the light of the constraints.
Step 6: Identify the proportion of the projects that lead to the optimum value of the objective function.
Step 7: Quantify the optimum solution.

PP 14 (Graphical Approach): A company is considering two divisible projects – A and B.

The cost of capital is 10%. The maximum capital for investment is $.25,000 at time 0 and $30,000 at
time 1.
The expected project cash flows and their NPVs are as follows
Year Project A Project B
$ $
0 (25,000) (20,000)
1 (15,000) (30,000)
2 80,000 70,000
NPV 52,000 20,000
There is capital rationing in both Year 0 and Year 1 because in each year the capital available for
investment is less than the total needed to invest in both projects.
Required
Identify the investment policy that will maximise the NPV, and calculate the NPV from the investment.
Solution:
Step 1: Define variables.
Let: a = the proportion of Project A undertaken
b = the proportion of Project B undertaken

Step 2: Construct an objective function

Maximise NPV = 52,000a + 20,000b

Step 3: Construct inequalities to represent the constraints.

Capital constraint at time 0: 25,000a + 20,000b < 25,000
Capital constraint at time :1 15,000a + 30,000b < 30,000

a is a proportion so the maximum value it can take is 1 (a <=1)

b is a proportion so the maximum value it can take is 1 (b<=1)
a cannot be negative a>=0
b cannot be negative b>=0

Step 4: Plot the constraints on a graph

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Step 5: Identify the feasible region.
This is an area that represents the combinations of projects that are possible in the light of the
constraints.
The feasible region for a solution is 0XYZ. Any point within this region is achievable. The optimal solution
is identified by moving the objective function line away from the origin – until it just touches the last
achievable point in the feasible region.

Step 6: Identify the proportion of the projects that lead to the optimum value of the objective
function.
The last achievable point is Z. Therefore the optimum solution is 100% investment in Project I and no
investment in Project II. This will maximise the NPV.

Step 7: Quantify the optimum solution.

The feasible region for a solution is 0XYZ.
Any point within this region is achievable. Maximise Rs.52,000a + Rs.20,000b
a = 1 and b = 0
Therefore NPV = Rs.52,000

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Multi-Period Capital Rationing – Divisible Projects
PP 15 (Simplex Method):

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