Topic 2 | BBMF2093 Corporate Finance

TOPIC 2: INVESTMENT APPRAISAL

Time Value of Money (Self-study with pre-recorded video BPP108 – 114)

Capital Budgeting

1. Capital budgeting can be defined as the process of identifying, analyzing and

selecting investment projects whose cash flows are expected to extend beyond
one year.
• A budget is a plan that details projected expenditures during some future
period.
• Analysis of potential additions to fixed assets.
• Long-term decisions; involve large expenditures.
• Very important to firm’s future.

2. Capital Budgeting: the process of planning for purchases of assets whose returns
are expected to continue beyond a year.
• Steps to capital budgeting:
➢ Estimate CFs (inflows & outflows).
➢ Assess riskiness of CFs.
➢ Determine the appropriate cost of capital.
➢ Find NPV and/or IRR.
➢ Accept if NPV > 0 and/or IRR > WACC.

3. Capital Expenditure: a cash outlay that is expected to generate a flow of future

cash benefits lasting longer than one year
• Capital expenditure decisions:
➢ Expand an existing product line
➢ Fixed asset investment
➢ Merger and acquisition
➢ Enter a new line of business
➢ Replacement of asset
➢ Advertising campaign
➢ R&D
➢ Education and training

4. Difference between independent and mutually exclusive projects

21
 Topic 2 | BBMF2093 Corporate Finance

• Independent projects – if the cash flows of one is unaffected by the

acceptance of the other.(choose as many projects as you want as long as you
have the fund)
• Mutually exclusive projects – if the cash flows of one can be adversely
impacted by the acceptance of the other.(can only choose 1 project)

5. Difference between normal and non-normal cash flow streams

• Normal cash flow stream – Cost (negative CF) followed by a series of positive
cash inflows. One change of signs.
• Non-normal cash flow stream – of signs. The cash flow profile is a series
of cash flows that, over time, don't go in only one direction.
• It is characterized by not just one, but several changes in the direction of
the cash flow. Eg: Cash flows for projects involving nuclear power plant
• Example 2.1
Inflow (+) or Outflow (-) in Year (N-Normal NN-Non-normal)
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN

Net Present Value (NPV) BPP114 (Try Activity 7)

1. Sum of the PVs of all cash inflows and outflows of a project:

CF1 CF2 CF3 CFn
NPV=CF0 + + + + ⋯⋯ +
(1+i)1 (1+i)2 (1+i)3 (1+i)n
N
CFt
NPV= ∑
(1+i)t
t=0

2. Example 2.2

Year 0 1 2 3
Cash Flow (RM) (100) 10 60 80
Discount rate = 10%
10 60 80
NPV= + 2 + - 100 = RM18.78
1.1 1.1 1.13

3. Rationale of the NPV method

22
 Topic 2 | BBMF2093 Corporate Finance

• NPV = PV of inflows – Cost = Net gain in wealth

• If projects are independent, accept if the project NPV > 0.
• If projects are mutually exclusive, accept projects with the highest positive
NPV, those that add the most value.
• In this example, accept S if mutually exclusive (NPVs > NPVL), and accept both
if independent.
4. Advantages of NPV method
• It is better because it considers cash rather than profit because cash is how
investors will eventually see their rewards
• It takes into account the timing of the cash flows is important because early
cash can be reinvested to earn interest.
• The acceptance of project only with positive NPV will increase the value of
the firm which is consistent with the goal of maximizing shareholder’s wealth.

Internal Rate of Return (IRR) BPP116 (Try Activity 8)

1. IRR is the discount rate that forces PV of inflows equal to cost, and the NPV =
0:
N
CFt
0= ∑
(1+IRR)t
t=0

2. IRR is an estimate of the project’s rate of return.

• If IRR > COST OF CAPITAL ACCEPT
• If IRR < COST OF CAPITAL REJECT

3. How is a project’s IRR similar to a bond’s YTM?

• They are the same thing.
• Think of a bond as a project. The YTM (yield-to-maturity) on the bond would
be the IRR of the “bond” project.
• Example 2.3:
Suppose a 10-year bond with a 9% annual coupon and $1,000 par value sells for
$1,134.20.
Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

4. IRR Formula
A
IRR = a + [ × (b - a)]
A+B
Where

23
 Topic 2 | BBMF2093 Corporate Finance

a is the lower rate of return.

b is the higher rate of return.
A is the NPV amount of the lower rate of return (ignore negative)
B is the NPV amount of the higher rate of return (ignore negative)

5. Example 2.4
Based on Example 2.2:
18.78
IRR = 10% + [ × (19% - 10%)] =18.23%
18.78 + 1.75
Assume the project above is named Project L while there’s another project named
Project S with IRR 23.56%, choose Project S with higher IRR.

6. Rationale for the IRR method

• If IRR > WACC, the project’s return exceeds its costs and there is some
return left over to boost stockholders’ returns.
If IRR > WACC, accept project.
If IRR < WACC, reject project.
• If projects are independent, accept both projects, as both IRR > WACC = 10%.
• If projects are mutually exclusive, accept S, because IRRs > IRRL.

7. Comparison of NPV and IRR methods BPP118

• NPV method better than IRR
• However, IRR familiar to many corporate executives
• NPV and IRR can provide conflict decision in investment appraisal

8. Impact on PV of an increase in the cost of capital

• Short-term
PV of RM100 due in 1 year @i=5%
100/(1.05)1 = RM95.24
PV of RM100 due in 1 year @i=10%
100/(1.1)1 = RM90.91
% change in PV = - 4.5%
• Long-term
PV of RM100 due in 20 years @i=5%
100/(1.05)20 = RM37.69
PV of RM100 due in 20 years @i=10%
100/(1.1)20 = RM14.86
% change in PV = - 60.6%
• So, early CFs, NPV will not decline very much if the cost of capital increases.

24
 Topic 2 | BBMF2093 Corporate Finance

9. Reinvestment rate assumptions

• NPV method assumes CFs are reinvested at the WACC.
• IRR method assumes CFs are reinvested at IRR.
• Assuming CFs are reinvested at the opportunity cost of capital is more
realistic, so NPV method is the best. NPV method should be used to choose
between mutually exclusive projects.
• Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is
needed.

Modified Internal Rate of Return (MIRR)

1. Since managers prefer the IRR to the NPV method, is there a better IRR
measure?
• Yes, MIRR is the discount rate that causes the PV of a project’s terminal value
(TV) to equal the PV of costs. TV is found by compounding inflows at WACC.
• MIRR assumes cash flows are reinvested at the WACC.
• Note: MIRR – Modified IRR

2. Example 2.5 (based on Example 2.2)

0 10% 1 2 3

-100 10 60 80
1.11
66
1.12
12.1
1.165-3
100 158.1

FV = PV(1 + i)n
80 + (60 × 1.1) + (10 × 1.12 ) = 100(1 + MIRR)3
3
80 + (60 × 1.1) + (10 × 1.12 )
MIRR= √ - 1 = 16.5%
100

3. Why use MIRR versus IRR?

• MIRR assumes reinvestment at the opportunity cost = WACC. MIRR also
avoids the multiple IRR problem.
• Managers like rate of return comparisons, and MIRR is better for this than
IRR.

25
 Topic 2 | BBMF2093 Corporate Finance

Payback Period (PP) BPP105 – 106 (Try Activity 2)

1. The number of years required to recover a project’s cost, or “How long does it
take to get our money back?”

2. Calculated by adding project’s cash inflows to its cost until the cumulative cash
flow for the project turns positive.

3. Payback = Number of years prior to full recovery + (Unrecovered cost at start

of year / CF during full recovery year)

4. Example 2.6 (based on Example 2.2)

Year Cash Flow Cumulative Cash Flow
0 -100 -100 30
1 10 -90 PP =2 + =2.375 years
80
2 60 -30
3 80 50

Assume project S payback is 1.6 years, and project S and L are mutually exclusive,
choose Project S as it has a shorter payback period compared to project L (2.375
years).

5. Strength and weaknesses of payback period

• Strengths
➢ Provides an indication of a project’s risk and liquidity.
➢ Easy to calculate and understand.
• Weaknesses
➢ Ignores the time value of money.
➢ Ignores CFs occurring after the payback period.

6. Discounted Payback Period

• Uses discounted cash flows rather than raw CFs.
• Example 2.7 (based on Example 2.2)

Discount Discounted Cumulated Discounted

Year Cash Flow
Factor (10%) Cash Flow Cash Flow
0 -100 1 -100 -100
1 10 0.909091 9.090909 -90.9091
2 60 0.826446 49.58678 -41.3223
3 80 0.751315 60.10518 18.78287

26
 Topic 2 | BBMF2093 Corporate Finance

41.32
PP =2 + =2.69 years
60.11

Mutually Exclusive Project with Unequal Lives

1. If a company is choosing between two mutually exclusive project with unequal

lives, an adjustment may be necessary.

There are two methods for making the adjustment:

i. Replacement Chains

ii. Equivalent Annual Annuities (EAA)

2. Example 2.8
Projects S and L are mutually exclusive, and will be repeated. If WACC = 10%,
which is better?
Expected Net CFs
Year Project S Project L
0 ($100,000) ($100,000)
1 59,000 33,500
2 59,000 33,500
3 - 33,500
4 - 33,500
59k 59k
NPVS = + - 100k = RM2,396.69
1.1 1.12
1 − (1.1−4 )
NPVL = 33.5k [ ] - 100k = RM6,190.49
0.1
• Is Project L better (higher positive NPV)?
Need replacement chain and/or equivalent annual annuity analysis.
• Replacement Chain
➢ Project S could be repeated after 2 years to generate additional profits.
➢ Use replacement chain to calculate extended NPV to a common life.
➢ Since S has a 2-year life and L has a 4-year life, the common life is 4 years.
➢ Use the replacement chain to calculate an extended NPVS to a common life.
➢ Since Project S has a 2-year life and L has a 4-year life, the common life
is 4 years.
59k 59k - 100k 59k 59k
NPVS = + + + - 100k = RM4,377.43
1.1 1.12 1.13 1.14
Therefore, choose project L due to higher positive NPV.

27