1

ADVANCE INVESTMENT APPRAISAL

Quick Revision of NPV – for Advance Investment Appraisal

1. Relevant Cash Flow Rules

For any decision making the relevant cash flows are Future Incremental Cash Flows and
Opportunity Cost (In any).
- Past Cost (Sunk/Committed) is Irrelevant
- Incremental Cash Flows (Either Fixed OR Variable)
- Non cash Items are Irrelevant (Like Depreciation or Apportion Cost)

NOTE: Interest Cost & Dividend always Irrelevant because it’s already part of Discount Rate
(WACC).

2. Inflation & Net Present Value

NPV = Future Cash Flows X Discount Rate
Inflation is a real life problem which affects us all.

In relation to appraising investments there are two impacts of inflation that you need to be able
to deal with.

These are firstly the impact on the estimated future cash flows and secondly the impact on the
discount rate:
Inflation with Discount rate

Nominal/Money Rate of Return - Return adjusted with Inflation

Real Return – Return without adjusted with inflation.

Fishers’ effect developing the relationship between returns and inflation as follows:
(1+N) = (1+R) X (1+I)
N = Nominal/Money Rate of Return
R = Real Rate of Return
I = General Rate of Inflation

Inflation with Future Cash Flows

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Future Real Cash Flows (Now/Current Terms): Future cash flows in current terms without
inflation adjusted.

Future Nominal Cash Flows (Money Term): Future Inflation adjusted future cash flows.

Future cash-flows either already inflation adjusted or need to incorporate inflation.

Inflated Cash Flows are “Cash flows that will actual arise in future.”

Inflation Classification is:

Specific Inflation – Specific to cash flows like material, labor, overheads etc/

General Inflation – Like average inflation rate of a particular economy.

There are two acceptable approaches to dealing with inflation in an NPV

analysis:

Two
Approaches

Real terms Money terms

Ignore Adjust both cash

inflation flows and the discount
rate.
throughout –

Real Cash Flows with Real DR Nominal Cash Flows with Nominal DR.
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3. Working capital investment for Investment Appraisal

When undertaking a major new investment, or project, there is often a need to invest in
working capital in addition to non-current assets. In particular there will normally be a need to
invest in inventory, and, if a credit period is offered to customers, a need to invest in
receivables.
The cash invested in working capital needs to be taken into account in an NPV evaluation.
Normally it is assumed that the cash invested in released at the end of the project’s life, but
because the time value of money is important, the timing of the investment in working capital,
and the release of funds from the investment in working capital, becomes important.

How do we calculate the working capital adjustment?

The approach is as follows.

1 Calculate the total working capital requirements at each point in time. This is the total
net amount that needs to be invested in working capital (the total amount of inventory
and receivables less the level of payables).
2 Calculate the net movement in working capital from period to period. This net
movement in working capital represents the amount that is tied up in, or released from
working capital during that period.

4. Tax Implications

Additional Tax Payments/Savings are the relevant cash flows for NPV.
Effectively for any taxable projects, need to calculate the taxable income and then apply the tax
rate accordingly.

Two Approaches:

1. Two Step Working Approach (As Normally Does in FM)

1st Calculate the tax payments/savings ignoring tax savings from capital allowance.

2nd Calculate the tax savings from capital allowance.

2. One Step Working Approach (As Normally Does in FM)

Calculate the taxable income/loss (after incorporating tax allowable depreciation) and
apply the Tax Rate to identify tax payments or savings
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Quick Revision - WACC

It means Investor’s required return and company/finance manger calculate WACC with view
point of investor.

Two Methods:
1. Valuation Method
2. CAPM

Valuation Method

Cost of Equity = Ke = by Dividend Growth Model

Ke = Do / Po
Ke = [Do(1+g) / Po] + g
Where:
Do = Current Dividend
Po= Current Share Price (Ex-Dividend)

Growth

By Gordon Model = b X r (Where b means retention ratio – other side of dividend payout ratio
and r = ROI/Ke)

By Geometric Mean Method

G = [Do/Db)]1/n - 1
Do = Current Dividend
Do = Base Year Dividend

Cost of Debts = Kd = by Valuation Model

1. Non Marketable Debts: Kd = Coupon Rate
2. Marketable Debts:

Redeemable Debts: Kd = IRR

Irredeemable Debts: Kd = Interest / Market Value of Debts
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CAPM Method

Ke by CAPM Method

Ke = Rf + (Rm – Rf) Be
Rf = Risk Free Rate of Return
Rm = Market Rate of Return
Rm – Rf = Risk Premium.
Be = Risk Adjustment Factor (Systematic Risk & Financial Risk) – Geared Beta.
Ba = Risk Adjustment Factor (Systematic Risk Only) – UnGeared Beta
Ba = Be X E / E + D (1-t) – Assuming Debt Beta 0

Important Points:

Ke by CAPM is superior method as compare to DVM

Investment Analysis with Expansion we use the existing Be & Ke for the WACC.

Investment Analysis with Diversification the following 3 steps need to follow for Be and Ke:
1. Un-Geared Beta from proxy company = Ba = Be X E / E + D (1-t)
2. Re-Geared the Beta with own Capital Structure – Rearrange this formula = Ba = Be X E /
E + D (1-t)
3. Use the Step 2 Be to calculate Ke

Kd by CAPM Method

Kd = Rf + (Rm – Rf) Bd
This formula is only applicable if Debt Beta is given.
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Important WACC Theory to recall from FM

Portfolio theory suggests that the total risk of a portfolio of investments can be reduced by
diversifying the investments held in the portfolio, e.g. by investing capital in a number of
different shares rather than buying shares in only one or two companies.

Even when a portfolio has been well-diversified over a number of different investments, there
is a limit to the risk-reduction effect, so that there is a level of risk which cannot be diversified
away. This undiversifiable risk is the risk of the financial system as a whole, and so is referred to
as systematic risk or market risk.
Systematic Risk (Market Risk or Inherent Risk) is the risk inherent to market as a whole, which
the shareholder can’t mitigate by holding diversified portfolio.

Diversifiable risk, which is the element of total risk which can be reduced or minimised by
portfolio diversification, is referred to as unsystematic risk or specific risk, since it relates
to individual or specific companies rather than to the financial system as a whole.

Portfolio theory is concerned with total risk, which is the sum of systematic risk and
unsystematic risk.

The capital asset pricing model assumes that investors hold diversified portfolios, and so is
concerned with systematic risk alone.

Business Risk is the risk related to the shareholder’s return fluctuates as a result of the
company’s business. Business risk linked to the extent to which the company’s profits (PBIT)
depend upon the fixed rather than variable operating cost.

Financial Risk relates to the risk that the shareholders return fluctuates as a result of the
level of debt the company undertakes. It arise where company is obliged to pay the interest
cost, which reduce the amount of profit available to be distributed to shareholders.
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Adjusted Present Value

The APV method shows how the NPV of a project and evaluates the project and impact of
financing separately.

The APV method described as a 'DIVIDE AND CONQUER' approach.

Broadly speaking, APV consist of two different decisions which are as follows:

Adjusted Present Value = Investment Side + Financing Side

Business Risk
Unchanged Change
Financial Risk Unchanged Existing WACC Risk Adjusted WACC
Change APV APV

** When financial risk changes due to undertake that project always use APV

The decision rule for the APV method

If, Adjust Present Value is positive = Accept the project

If, Adjust Present Value is Negative = Reject the project

Investment Evaluation by APV Method:

APV method splitting the evaluation of investment into two components:

• Project’s value with operating cash flows without considering financing matters (Base
Case NPV) and
• Value of Financing Side Effects.

This approach examines directly the effects of the financing methods that are being used,
which, for this investment, relate to tax relief on interest payments, the benefit of a subsidized
loan, and issue costs associated with the right issue.

The base case NPV of the project if negative and value of financing side effect not creating the
total positive APV and total APV is negative.

On that basis the project should be rejected.

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Performa of Adjusted Present Value (APV):

Base Case NPV X

Financing Decisions
Present value of issue cost
Equity (X)
Debt XXX

Present value of Tax Shield –( Considering Debt Capacity)

From Simple Loan X
From Subsidized Loan X

Present Value of Subsidized Loan X X

Adjusted Present Value X

Investment Decision (Base Case NPV)

The base case NPV is calculated with the consideration of Systematic Risk only (assuming the
project is financed entirely by equity finance), so that the method of financing is ignored.

Normal DCF techniques are used to establish the expected cash flows for the project. To
calculate base case NPV identify all operating cash flows of the project from the case and
calculate the present value with the discount factor of KE - ug.

How to identify KE – ug ?
1. CAPM Method:

• Identify the Beta Asset for the relevant industry. In case of project about diversification,
convert geared beta (Beta Equity) of proxy company to an un-geared beta (Beta Asset).,
and then
• Use this Beta Asset or ungeared beta and the CAPM formula to establish the cost of equity
in an ungeared company, and using this discount rate as KEug
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2. Modigliani and Miller's Proposition 2

As part of their theory, they derived a formula which can be used to derive a firm's cost
of equity:

ke = ke i + (1 – T)(ke i – kd )(Vd / Ve)

(This formula is given on the formula sheet)

Explanation of terms

Ve and Vd are the market values of equity and debt respectively.

kd is the (pre-tax) return required by the debt holders.

T is the corporation tax rate.

Ke i is the cost of equity in an equivalent ungeared firm.

ke is the cost of equity in the geared firm.

Financing Decision

Financing Side Effects Considering the value of the project with:

1. Present value of Issuance Cost

2. Present value of Tax Shield (Considering the Debt Capacity)
a. Simple Loan

b. Subsidized loan
3. Value of Subsidized Loan

As all financing cash flows are facing lower risk as compare with equity for this reason they
are discounted at either the cost of debt (Kd) or Risk Free Rate.

Note: If cost of debt is not available or cannot be calculated then risk free rate (RF) can be used
for discounting the financing cash flows

Grossing up:
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A firm will know how much finance is required for the investment. Issue costs of finance will
be quoted on the top. It will therefore be necessary to gross up the funds to be raised
Present value of Issuance cost:

Issue costs might be an allowable expense for the tax purposes.

When they are tax- allowable, the PV of issue costs must allow for the reduction in tax
payments that will occur. The PV of the issue costs is therefore net of the present value of any
tax relief on the costs.

As always calculation involving debt must take account of the tax effects. Normally, situation is
as follows:

Issuance Cost

Equity Issue Debt issue

Cost cost

Not tax allowable Tax allowable

Expense Expense

Issue cost arrangement either externally or internally, but in any case issue cost is relevant for
the APV calculation.

If examiner is not specifically mention (or silent) about issue cost, you can take assumption in
any way.
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Assumptions of APV

1. Many of the inputs – Tax Rates, Capital Allowance Rates, the various cost and prices,
units produced and sold, estimations of exchange rates (in case of foreign investment
appraisal) the rate of inflation will change as stated over the life of the project. In reality
any of these estimates could be subject to change to a greater degree and it would be
better to conduct uncertainty assessment like sensitivity analysis or others.
2. In APV the tax shield is based on debt capacity but not the actual amount of debt
finance.
3. Time duration of the project
4. Un-geared cost of equity Keug is used to represent the business risk attributable to the
new venture and calculation is based on Modigliani and Miller’s proposition 2.
5. Un-geared cost of equity Keug doesn’t include financial distress costs which may or may
not be reasonable.
6. There are no adverse affect of taking on the extra debts eg worsening credit rating and
impact on business.

Limitations of APV

APV offers an opportunity to evaluate investments where gearing and risk differs from the
company's existing operation. However, it has its limitations including:

1. The equation for accept betas in a taxed world assumes that cash flows are
perpetuities. The cash flows for this investment are not perpetuities
2. Investment evaluation ignores the potentially valuable option to continue
operations after the initial time period. Any final decision should include consideration
of the financial effects of this option and any other opportunities that might arise as a
result of diversification.)
3. APV requires the identification of all financing side effects and their discount at
a rate reflecting their risk in a complex investment situation, especially
overseas investment; it might be difficult to identify relevant financing side effects,
and their appropriate discount rates.
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APV Theory Examined At:

1. SEPTEMBER 2019 – Q1 (PART A) OKAN – 4 MARKS

Discuss why a company may prefer to use the adjusted present value (APV)
method, rather than the net present value (NPV) method.

Adjusted present values (APVs) separate out a project’s cash flows and allocate a specific
discount rate to each type of cash flow, dependent on the risk attributable to that particular
type of cash flow.

Net present value (NPV) discounts all cash flows by the average discount rate attributable to
the average risk of a project.

One reason why APV may be preferable to NPV is because by separating out different types of
cash flows, the company’s managers will be able to see which part of the project generates
what proportion of the project’s value.

Furthermore, allocating a specific discount rate to a cash flow part helps determine the value
added or destroyed.

In this example, Okan Co is able to determine how much value is being created by the
investment and how much by the debt financing. For complex projects, investment related cash
flows could be further distinguished by their constituent risk factors, where applicable.
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2. MARCH 2019 – Q1 (N/A)

NPV vs APV Approach

Investment must be appraised with the consideration of discounting the relevant cash flows
with their associated risk. There are methods for evaluating the long-term investment
opportunities:

APV Method
The method separates the investment decision from the financing decision by breaking the
traditional DF into two parts.

The first part (the investment decision) discounts cash flows at an equity rate of return/
cost of equity (Key) to calculate base case npv.

The second part (the financing decision) discounts the interest tax shield to the present
value at a rate of return that reflects the risk in actually achieving these tax benefits.

The two parts are then summed to derive the value of the project for the business.

NPV Method Using WACC

The NPV method of investment appraisal is to discount the cash flows of a project at the cost of
capital (WACC). This might be the existing WACC (expansion) or risk adjusted WACC
(diversification).

Difference of WACC & APV Approach

APV is used instead of NPV for appraising the project when the capital structure and the
financial risk of the new project are different from the existing structure of the company.

The traditional discounted cash flow method where in debt free cash flows are discounted to
the present at the WACC may not be appropriate in every circumstance. The WACC assumes a
static debt to equity ratio presumably at an optimal capital structure.
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However, many companies do not expect to have static level of debt to equity, particularly in
situations involving highly leveraged transactions. Under these types of situations, the Adjusted
Present Value Method may be a better method. As such, the APV can also be used as a
management tool to break out the value created from specific managerial decisions and it is
based upon a principle of value addition that analysts can use with valuations.

APV method makes more flexible enough to cover many different types of real world financing
arrangements such as:
• Change in gearing level over the project life
• Issuance cost of equity and debt properly
• The proper impact of subsidized loan

Using debt financing has the tax advantage and interest payments are deductible. This tax
deduction has a source of value for the firm. In the normal NPV calculation, this additional value
is accounted for in the WACC.

Unlike APV, the normal assumption in NPV is that all cash flows are financed using the same
WACC and remain constant each year. Therefore, when dealing with changing financial risk and
more complicated financial situation, APV is preferable appraisal method over NPV.
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Exam Analysis – APV

1. Exam Scope 25 marks to 50 marks.

2. Core topic is calculation but always examined with significant part of theory.

3. Past exam analysis since December/10

Nos. Session Marks Name of Question

1
September/19 50 Okan – (Integrated with Forex Hedging)
2
December/18. 25 Amberle
3
March/18. 25 Tippletine
4
March/16.
N/A
5
March/17.
6
June/14. 25 Burung
7
December/11. 50 Tramont
8
December/10. Fubuki
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Modified Internal Rate of Return (MIRR)

Internal Rate of Return (MIRR)

The IRR of any investment is the return that is delivered by the project (The Project’s Potential).
Alternatively, the IRR can be thought of the discount rate at which the NPV is equal to zero.

IRR = a + NPVa × (b– a)

——————
(NPVa – NPVb)

Limitations of IRR:

1. Non-Conventional Cash-flows:
Conventional cash flows are those which stay positive after the investment rather than
moving back to the negative side. E.g
Year Conventional Non Conventional
Cash-flow Cash flow
0 $ (1,000,000) $ (1,000,000)
1 $ 500,000 $ 550,000
2 $ 650,000 $ (300,000)

In case of Non-Conventional Cash-Flows there would usually be a problem of Multiple

IRR, whereas there should be only one level of project’s Potential.

2. Mutually Exclusive Project

When dealing with independent investments, the IRR should be the same as NPV but in
mutually exclusive investments IRR fails to recognise the magnitude of the NPV and
rather is unable to decide which project issuperior.
E.g.
Time Project A Project B
0 $(10,000) $(10,000)
1 $ 12,000 $ 1,000
2 $ 625 $ 13,200
@ Discount rate = 10%
Calculate NPV and IRR.
Solution: Project A Project B
NPV @ 10% 1,426 1,818
IRR 25% 20%
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In summary the NPV profiles differ due to two reasons:

a) Differences in the timing of the cashflows for each project.
b) Differences in the project sizes (or project scales).

3. Re-Investment Rate
The problem with selecting investments based on the higher IRR is that it makes an
assumption that cash flows can be reinvested at the IRR over the life of the project.
In contrast, the NPV method assumes that cash flows can be invested at the cost of
capital over the life of the p
project.
If the assumption that IRR as a reinvestment rate is valid, then IRR technique will be
superior. However, it is unlikely that this will be the case and therefore the NPV method
is likely to be superior. The better reinvestment rate assumption will be cost of capital
used for the NPV method.

Modified
odified Internal Rate of Return (MIRR)

The modified internal rate of return (MIRR) is a form of IRR that overcomes all the limitations of
IRR method thereby calculating the projects true potential.The MIRR is calculated on the basis
of investing the inflows at the cost of capital.
Exam Formula:

Where PVR = the PV of the return phase

PVI= the PV of the investment phase
re= the cost of capital

Advantages of MIRR.
1. The re-investment
investment rate is the company’s co
cost of capital.
2. In many cases where IRR and NPV methods conflict MIR will give the same result as NPV.
3. It is theoretically the correct method of checking the projects potential.

Disadvantage of MIRR.
1. Like IRR, investor may reject a project with lower rate of return even though it
generates a larger increase in wealth.
2. A high return project with a short life may be preferred over a lower return project with
a longer life.
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Example:

A project has the following cash flows:

Year Cash Flow
0 $(900)
1 $ 400
2 $ (500)
3 $ 800
4 $ 600
5 $ 500

Calculate MIRR Using Cost of Capital 8%

Example Solution:

MIRR
Year Cash Flow PV(Return Phase) PV(Investment Phase)
0 $ (900) $(900) x (1.1)^0 = (900)
1 $ 400 $400 x (1.1)^-1 = 363.64 -
2 $ (500) - $(500) x (1.1)^-2 = (413.22)
3 $ 800 $800 x (1.1)^-3 = 601.05 -
4 $ 600 $600 x (1.1)^-4 = 409.81 -
5 $ 500 $500 x (1.1)^-5 = 310.46 -
1684.78 1313.22

MIRR =[(1684.78/1313.22)^1/5 x (1+10%)] – 1

MIRR = 15.62%
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Payback Period, Discounted Payback Period and Duration

Traditional payback period

Payback period measures the length of time it takes for the cash returns from a project to cover
the initial investment.

The main problem with payback period is that it does not take account of the time value of
money and the full cash flows throughout the life of the project.

Discounted payback period

Hence, the discounted payback period can be computed instead. Discounted payback period
measures the length of time before the discounted cash returns from a project cover the initial
investment.

The shorter the discounted payback period, the more attractive the project is. A long
discounted payback period indicates that the project is a high risk project. However, the
problem with not taking, the full cash flows throughout the life of the project, into account
persists.

Example:
A project with the following cash flows is under consideration:
Year 0 1 2 3 4
$000 (20,000) 8,000 12,000 4,000 2,000

Cost of capital 8%
Required:

Calculate: Payback Period

Discounted Payback Period.

Duration (Macauley duration)

Duration measures the weighted average time to recover the present value of the project (if
cash flows are discounted at the cost of capital). Duration captures both the time value of
money and the whole of the cash flows of a project. It is also a measure which can be used
across projects to indicate when the bulk of the project value will be captured.
However, if cash flows are discounted at the project's IRR, it can be used to measure the time
to recover the initial investment. As well as being used in project appraisal, duration is
commonly used to assess the likely volatility (risk) associated with corporate bonds.
Projects with higher durations carry more risk than projects with lower durations.
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Modified Duration:

Modified Duration = Duration / (1+ Cost of Capital)

Comparison of Duration and Modified Duration:

Duration represents the weighted average time until the cash flows are received and is
measured in time period (Normally Years).

Whereas, the Modified Duration is the name given to the price sensitivity and is the percentage
change in price for a unit change is return (Yield).

Practice Question:

A project with following cash flows is under consideration:

Year Cash Flows

$(000)
0 (127)
1 (37)
2 52
3 76
4 69
5 44
6 29

Calculate:

Duration and Modified Duration.

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CAPITAL RATIONING
Capital rationing was first introduced in Paper FM. A brief recap follows:

Shareholders wealth is maximized if a company undertakes all possible positive NPV projects.

Capital rationing is a situation in which a company has a limited amount of capital to invest
in potential projects, such that the different possible investments need to be compared
with one another in order to allocate the capital available most effectively.

If an organisation is in a capital rationing situation it will not be able to enter into all
projects with positive NPVs because there is not enough capital for all of the
investments.

Soft capital rationing is brought about by internal factors and Hard capital rationing is
brought about by external factors.

Soft capital rationing may arise for one of the following reasons.

1. Management may be reluctant to issue additional share capital because of concern

that this may lead to outsiders gaining control of the business.

2. Management may be unwilling to issue additional share capital if it will lead to a

dilution of earnings per share.
3. Management may not want to raise additional debt capital because they do not
wish to be committed to large fixed interest payments.

4. Management may wish to limit investment to a level that can be financed solely
from retained earnings.

5. They may not want to grow the company too quickly.

Hard capital rationing may arise for one of the following reasons.

1. Raising money through the stock market may not be possible if share
prices are depressed.

2. There may be restrictions on bank lending due to government control.

3. Lending institutions may consider an organisation to be too risky (eg, too highly
geared, poor prospects) to be granted further loan facilities.

4. The costs associated with making small issues of capital may be too great.
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This Capital Rationing Situation (Shortage of Funds) with respect to time period classified
as follows

1. Single Period Capital Rationing

2. Multi Period Capital Rationing

1. A single period Capital Rationing only – dealt with as in limiting factor analysis by
calculating profitability indexes (Pl)

Pl = NPV / PV of capital invested

Question: Single Period Capital Rationing

Peel Co has identified 4 positive NPV projects, as follows:

Project NPV ($m) Investment at t0 ($m)

A 60 9

B 40 12

C 35 6

D 20 4

Peel Co can only raise $12m of finance to invest now.

Required:

Advise the company which project(s) to accept if the projects are:

(i) Independent and divisible

(ii) Independent and indivisible
(iii) Mutually exclusive
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2. MULTI PERIOD CAPITAL RATIONING

A solution to a multi-period capital rationing problem cannot be found using Pls. This method
can only deal with one limiting factor (i.e. one period of shortage). Here there are a number
of limiting factors (i.e. a number of periods of shortage) and linear programming techniques
must therefore be applied.

In the exam you will not be expected to produce a solution to a linear programming problem,
but you may be asked to formulate the linear programming.

In practice, long term capital rationing is a signal that the firm should be looking to expand its
capital base through a new issue of finance to the markets.

Example 1

A company has identified the following independent investment projects, all of which are
divisible and exhibit constant returns to scale. No project can be delayed or done more than
once.

Project cash flows at time: 0 1 2 3 4

$000 $000 $000 $000 $000
A -10 -20 +10 +20 +20
B -10 -10 +30 - -
C -5 +2 +2 +2 +2
D - -15 -15 +20 +20
E -20 +10 -20 +20 +20
F -8 -4 +15 +10 -

There is only $20,000 of capital available at t0 and only $5,000 at T1, plus the cash inflows from the
projects undertaken at T0. In each time period thereafter, capital is freely available. The appropriate
discount rate is10%.

Required:
Formulate the linear programme.
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Solution:

Since our objective is to maximize the total NPV from the investments the first
(additional) stage will be to calculate those NPVs at a discount rate of 10%.

Project NPV @ 10%

$000
A +8.77
B +5.70
C +1.34
D +2.65
E +1.25
F +8.27

We now progress as for a standard liner programme:

(1) Define the unknowns

The linear programme will then select the combination of projects, which will
maximize total NPV.

Therefore

Let a = the proportion of project A

undertaken Let b = the proportion of

project B undertaken Let c = the

proportion of project C undertaken Let d

= the proportion of project D undertaken

Let e = the proportion of project E

undertaken Let f = the proportion of

project F undertaken And

Let z = the NPV of the combination of projects selected.

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(2) Formulate the objective function

The objective function to be maximized is:

z = 8.77a +5.70b + 1.34c + 2.65d + 1.25e + 8.27f.

(3) Express the constraints in terms of inequalities including the non-negativities

Time 0 10a + 10b + 5c + 20e + 8f ≤ 20

Time 1 20a + 10b + 15d + 4f ≤ 5 + 2c
+ 10e Also 0 ≤ a, b, c, d, e, f ≤ 1

(4) Interpret the results

The linear programme when solved will give values for a, b, c, d, e and f. These will
be the proportions of each project which, should be undertaken to maximize the
NPV – an amount given by z.

Further details on interpretation

The objective function (z) is the maximum NPV earned. The will be the sum of the
NPVs earned from each project. Since they may each be done only in part, the full
NPV from each one is multiple by the proportion of it to be undertaken (a, b, c etc.)
and these are then summed together to give the objective function.

The main constraints simply say that you cannot spend any more money than you
have available.

- The first constraint relates to the limited capital available at T0.

- How much of the T0 capital for each project will actually be needed, depends on
the proportions of each project undertaken. The full T0 amounts are therefore
multiplied by the proportions to be undertaken, and the sum of those amounts
must not exceed the $20,000 available.

- The second constraint relates to the limited capital available at T1.

- Here the financial situation is eased because projects C and E have positive cash
inflows at T1 and these flows can be used to fund investment needs at that time.

- The funds required by projects using limited cash (A, B, C, D and F) are therefore
multiplied by the proportions to be undertaken. This amount must be less than
what is available – the $5,000 plus the funds brought it by whatever proportions
of C and E we end up choosing to do.
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The third constraint is a summarized one. It shows that none of the projects can be done
more than once (i.e. must be ≤ 1) and that is not possible to do a negative amount of any
project (they must be ≥ 0). This second non-negative rule is essential. If it were not
included, a computer model may well compute that effectively ‘undoing’ a project frees up
cash and include it in a solution!

Example 2

Jacqui Co is considering investing in three projects over the next two

years. The level of investment required for each project is as follows:

$000 T0 T1 T2
Project A 500 200 0
Project B 600 200 400
Project C 1,000 100 500

After these amounts have been invested, all three projects have several years of positive
cash inflows, and all three projects have positive NPVs as follows:

$000 NPV
Project A 3,050
Project B 2,885
Project C 7,560

Jacqui Co faces a capital rationing constraint at each of T0, T1 and T2.where spending limits
are:
• $2,000,000 at T0
• $300,000 at T1
• $700,000 at T2

Required:
On the assumption that none of the projects can be deferred and all of the projects can be
scaled down but not scaled up, formulate an appropriate capital rationing model that
maximizes the net present value for Jacqui Co.

(Finding a solution for the model is not required)

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Example 3

The following linear programming model has been formulated to find the optimal
proportions of projects A, B and C where capital is limited to $40,000 at the start of the
first year and $35,500 at the start of the second year.

Maximize 23,245XA + 28,414XB + 37,939XC

Subject to 15,000XA + 25,000XB + 35,000XC ≤ 40,000

25,000XA + 15,000 XB + 15,000 XC ≤ 35,500

Xƃ XBƒ XC ≤ 1
Xƃ XBƒ XC ≤ 0

A computer provides the solution of the above problem as follows:

Project Proportion
A 0.988
B 0
C 0.719

Shadow prices:
1st constraint (the $40,000 first year budget) = 0.922
2nd constraint (the $35,000 second year budget) = 0.3755

Interpretation of solution

The solution indicates that 0.988 of Project A and 0.719 of Project C should be initiated.
This investment plan uses all the funds available in the first year and the second year.

The resulting value of objective function, NPV = $50,244

The shadow prices indicate the amount by which the NPV could be increased if the budgetary
constraints could be relaxed.

For every $1 increase in finance in the first year, $0.922 extra NPV would be obtained. For
every
$1 relaxation of the constraint in the second year, $0.3755 extra NPV would be obtained.

The shadow prices indicate that extra funds in the first year are worth approximately three
times those in the second year. This fact may give management some guidance in their
considerations of various alternative sources of capital.
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It is assumed that each project is divisible and that there is a linear relationship between
the proportion of each project undertaken and the NPV generated.