Chapter 5 – Investment Decisions
in annual profit. Investors expected a 15% return on
Investment
 An asset or item acquired with the goal of
generating income or appreciation.
Appreciation refers to an increase in the value
of an asset over time.
 When an individual purchases a good as an
investment, the intent is not to consume the
good but rather to use it in the future to create
wealth.
 Involves putting capital to use today in order to
increase its value over time.
 An investment can refer to any medium or
mechanism used for generating future income,
including bonds, stocks, real estate property, or
a business, among other examples.
(https://www.investopedia.com/terms/i/invest
ment.asp)
 All investments represent a trade-off between
possible future gain and current sacrifice.
(Froeb, et.al.)
 The act of buying financial assets with the
potential to increase in value, such as stocks,
bonds, or shares in Exchange Traded Funds
(ETF) or mutual funds. Investments are not
guaranteed to hold or increase their value over
time.
Break-Even Analysis
 Break-even quantity is equal to fixed cost
divided by the contribution margin. If you
expect to sell more than the break-even
quantity, then your investment is profitable.
 BEQ = Total Fixed Costs/Contribution Margin
(Price per unit – MC or VC per unit)
Example: In summer 2007, Bert Matthews was
contemplating purchasing a 48-unit apartment building.
The building was 95% occupied and generated $550,000
their capital. The bank offered to loan Mr. Matthews
80% of the purchase price at a rate of 5.5%. Mr.
Matthews computed the cost of capital as a weighted
average of equity and debt.
 20%*(15%) + 80%*(5.5%) = 7.4%
 Profit/cost of capital : $ 550,000/.074 = $7.4
million
 Mr. Matthews could pay no more than
$550,000/7.4% = $7.4 million and still break
even.
 Mr. Matthews decided not to buy the building.
A good decision – one year later, the cost of
capital was 10.125% and Mr. Matthews could
offer only $5.4 million for the building.
 $550,000/10.125% = $550,000/.10125 =
5,432,098.76 rounded off to $5.4 million
Compounding
 the ability of an asset to generate earnings,
which are then reinvested or remain invested
with the goal of generating their own earnings.
 In other words, compounding refers to
generating earnings from previous earnings.
 Formula: (same as time value of money)
(Future value, k periods in the future) = (present
value) x (1 + r)^k
 present value
 interest rate (r)
 number of years (k)
Example: : If you invest $1 (present value) today at a
10% (r), then you would expect to have $1.10 in one
year.
 In two years, $1 becomes $1.21 = $1.10 x (1+.1)
 In three years: $1 x (1+0.1)^3 = $1.331
What is the future value of Php10,000 after 5 years at
5% p.a. compounded?
 FV = 10,000 x (1+0.05)^5
 Php12,762.8
Rule of 72 Example: A bond can have a par value of $1,000 and be
priced at a 20% discount, which is $800. In other words,
 a simplified formula that calculates how long the investor can purchase the bond today for a discount
it'll take for an investment to double in value, and receive the full-face value of the bond at maturity.
based on its rate of return. The difference is the investor's return.
 estimates the number of years it takes to
double your money at a specified rate of return. Present value = $1,000/(1+ r)^k
 applies to compounded interest rates and is = $1,000/(1+ 0.2) = $833
reasonably accurate for interest rates that fall in
What will be the selling price of a bond at face value
the range of 6% and 10%.
Php20,000 today with 5 years maturity at 10%
 Formulas:
discount?
Years to double = 72/interest rate*100
Present value=Php20,000/(1+ 0.10)^5 = Php12,422.36
 Interest rate – the rate of return on an
 Discounting (the inverse of compounding):
investment.
Present value = (future value, k periods in the future)/(1
FV = PV*(1+r)^t
+ r)^k
 FV is future value, PV is present value, r is the
Given: future value, periods in the future or years (k),
rate, and the t is the time period.
discount rate (r)
Discounting
Calculate for the present value.
 the process of determining the present value of
Example: At a 10% r, $1 is worth:
a payment or a stream of payments that is to be
received in the future.  Next year: ($1)/1.1 = $0.91
 Given the time value of money, a dollar is worth  Two years: ($0.91)/1.1 =$0.83
more today than it would be worth tomorrow.  $1/(1+r)^k=$1/(1+r)^k=$1/(1.1)^2=$1/1.21
 The primary factor used in pricing a stream of = $0.83
tomorrow's cash flows.  Three years: ($0.83)/1.1 = $0.75
 From a business perspective, an asset has no
value unless it can produce cash flows in the Net Present Value: Formulas
future. Stocks pay dividends. Bonds pay
interest, and projects provide investors with
incremental future cash flows. The value of
those future cash flows in today's terms is
calculated by applying a discount factor to
future cash flows.
 A higher discount indicates a greater the level
of risk associated with an investment and its
future cash flows.
 Discounting helps you figure out if future gains
are larger than current sacrifice.

NPV = Sum of Inflows in present value – Sum of

Outflows in present value
Choosing Between 2 Projects based on NPVs
NPV = SUM OF INFLOWS – OUTFLOW
Project 1:
 NPV = $100.88 – 100
 = $0.88
Project 2:
 NPV = ($52.63 + $46.17) - $100
 = $98.8 - $100
 = -$1.2
NPV & Economic Profit
 Projects with a positive NPV create economic
profit.
 Only positive NPV projects earn a return higher
than the company’s cost of capital.
 Projects with negative NPV may create
accounting profits, but not economic profit.
 In making investment decisions, choose only
projects with a positive NPV.
Application: Break-even Analysis
Nissan’s popular truck model, the Titan, had only two
years remaining on its production cycle. Redesigning the
“Titan” would cost $400M.
 Cost of capital was 12%, implying annual fixed
cost of $48M
 Contribution margin on each truck is $1,500
 Break-even quantity is 32,000 trucks
 TR = price x quantity, TC = FC + VC
 TR = $1,500 x 32,000 units = $48 M
TC = $400M x 12% = $48 M
 The decision to redesign or not came down to a
break-even analysis
Nissan had a 3% share of the market, implying only
12,000 Titan sales per year – not enough to break even.
Instead, they decided to license the Dodge Ram Truck,
which would reduce the fixed cost of redesign, and a
lower break-even point.
Advice on Break-even Analysis
 Remember this advice: Do not invoke break-
even analysis to justify higher prices or greater
output.
 Managers sometimes believe they must raise
prices to cover fixed costs, or they must sell as
much as possible to make average costs lower
 These are extent decisions though!
- They require marginal analysis, not break-
even.