Chapter 4: Rate of Return of an Investment

Instructor: Selim MANKAÏ

Université d’Auvergne
Semester 2, 2019

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 Learning objective

‒ Discuss capital budgeting

‒ Calculate the major capital budgeting decision criteria
‒ Measure the return of a portfolio

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 Capital budgeting

Capital budgeting is the whole process of analyzing projects

and deciding which ones to include in the capital budget.

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 Project categories

Firms generally categorize projects and then analyze them

in each category somewhat differently:
1. Replacement : needed to continue current operations
2. Replacement: cost reduction
3. Expansion of existing products or markets.
4. Expansion into new products or markets.
5. Safety and/or environmental projects.
6. Mergers
7. Other projects.
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 Structure of cash flow

An investment project involves an initial expenditure and

future cash flows related to the project.
The comparison between these flows will be made on the
same date, in general, the date 0.

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 Cash flow

Cash flow is the net amount of cash and cash-equivalents

moving into and out of a business.
Positive cash flow indicates that a company's liquid assets
are increasing, enabling it to settle debts, reinvest in its
business, return money to shareholders, pay expenses and
provide a buffer against future financial challenges.

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 First criterion: Payback Period Method

Payback period is the time in which the initial cash

outflow of an investment is expected to be recovered from
the cash inflows generated by the investment.

How long does it take the project to “pay back” its

initial investment?

Payback Period = number of years to recover initial costs

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Payback Period Method : Formula

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 Payback Period Method: Decision Rule

Accept the project only if its payback period is less than the
target payback period.

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 Payback Period Method : Example

A Firm is deciding between two machines (Machine A

and Machine B) in order to add capacity to its existing
plant. The company estimates the cash flows for each
machine to be as follows:

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Payback Period Method : Example

Cumulative cash flows for Machine A and Machine B

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Payback Period Method : Example

Cumulative cash flows for Machine A and Machine B

Payback period for Machine A = 4 + 1,000/2,500 = 4.4

Payback period for Machine B = 2 + 0 = 2.00

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 Payback Period Method: Advantages

- Payback period is very simple to calculate.

- It can be a measure of risk inherent in a project. Since
cash flows that occur later in a project's life are considered
more uncertain, payback period provides an indication of
how certain the project cash inflows are.
- For companies facing liquidity problems, it provides a
good ranking of projects that would return money early.

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 Payback Period Method: Disadvantages:

- Payback period does not take into account the time

value of money which is a serious drawback since it can
lead to wrong decisions. A variation of payback method
that attempts to remove this drawback is called discounted
payback period method.
It does not take into account, the cash flows that occur
after the payback period.

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 Second criterion: Net Present Value

• Net present value (NPV) of a project is the potential

change in an investor's wealth caused by that project
while time value of money is being accounted for.
• Net present value calculations take the following two
inputs:
- Projected net cash flows in successive periods from the
project.
- A target rate of return i.e. the hurdle rate.

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 Net Present Value : Formula

NPV is equal to the present value of net cash inflows

generated by a project less the initial investment on the
project:

r : discount rate
CFj: net cash flow at time (j)

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 Hurdle rate

Hurdle rate is the rate used to discount the net cash

inflows. Weighted average cost of capital (WACC) is the
most commonly used hurdle rate.

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 Net Present Value : Decision Rule

- In case of independent projects, accept a project only if

its NPV is positive, reject it if its NPV is negative and stay
indifferent between accepting or rejecting if NPV is zero.

- In case of mutually exclusive projects (i.e. competing

projects), accept the project with higher positive NPV.

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Net Present Value : Example

Find the NPV of project S:

Discount rate : 10%

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Net Present Value : Example

= 78.82

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 Net Present Value : Advantages

Net present value accounts for time value of money

which makes it a sounder approach than other investment
appraisal techniques which do not discount future cash
flows such payback period and accounting rate of return.

Net present value is even better than some other

discounted cash flows techniques such as IRR. In situations
where IRR and NPV give conflicting decisions, NPV decision
should be preferred.

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 Net Present Value : Disadvantages

NPV is sensitive to changes in estimates for future cash

flows, salvage value and the cost of capital.
Net present value does not take into account the size of
the project (initial outlay).
For example, say Project A requires initial investment of
$4 million to generate NPV of $1 million while a competing
Project B requires $2 million investment to generate an
NPV of $0.8 million. If we base our decision on NPV alone,
we will prefer Project A because it has higher NPV, but
Project B has generated more shareholders’ wealth per
dollar of initial investment ($0.8 million/$2 million vs $1
million/$4 million).

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 Criterion 3: Profitability Index (PI)

Profitability index is an investment appraisal technique

calculated by dividing the present value of future cash
flows of a project by the initial investment required for the
project.

Present Value of Future Cash Flows


Initial Investment Required

Net Present Value

1
Initial Investment Required

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 Profitability Index: Decision Rule

- Accept a project if the profitability index is greater than 1

- Stay indifferent if the profitability index is 1
- Don't accept a project if the profitability index is below 1.

Profitability index is sometimes called benefit-cost ratio

too and is useful in capital rationing since it helps in ranking
projects based on their per dollar return.

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 Profitability Index : Example

Firm ABC is undertaking a project at a cost of $50 million

which is expected to generate future net cash flows with a
present value of $65 million. Calculate the profitability
index.

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 Profitability Index : Example

Profitability Index:
$65M
PI   1.3
$50M
Net Present Value :

 $65M  $50M  $15M

The information about NPV and initial investment can be

used to calculate profitability index as follows:

$15M
 1  1.3
$50M

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 Profitability Index : Advantages

- May be useful when available investment funds are

limited
- Easy to understand and communicate
- Correct decision when evaluating independent projects

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 Internal return rate

Internal rate of return (IRR) is the discount rate at which

the net present value of an investment becomes zero.
IRR is the discount rate which equates the present value
of the future cash flows of an investment with the initial
investment.

N
CFk
I0   0
k 1 (1  IRR )
k

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 Internal return rate: Decision Rule

A project should only be accepted if its IRR is NOT less

than the target internal rate of return.
When comparing two or more mutually exclusive
projects, the project having highest value of IRR should be
accepted.

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 Unicity of the IRR
For an integer k : 0<k< n:
if CFt ≤0 for 0≤ t ≤ k and CFt ≥0 for k+1≤ t ≤ n
Or
si CFt ≥0 for 0≤ t ≤ k and CFt ≤0 for k+1≤ t ≤ n

Hence, there is a unique IRR

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 Internal return rate : Example

Find the IRR of an investment having initial cash outflow

of $10,000. The cash inflows during the first and second,
years are expected to be $5,200 and $10,000 respectively.

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 Internal return rate : Example

5000 10000
NPV (i=25%)= 10000   2
 400  0
1.25 (1.25)

5000 10000
NPV (i=30%)= 10000   2
 236.69  0
1.3 (1.3)

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 Internal return rate: Example

Linear interpolation:

i2  TRI VAN 2  0

i2  i1 VAN 2  VAN1

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 Internal return rate: Example

Linear interpolation:

i2  TRI VAN 2  0

i2  i1 VAN 2  VAN1

 VAN 2 
 TRI  i2  (i2  i1 ) 
 VAN 2  VAN1

236.69
 0.3  (0.3  0.25)( )
236.69  400
 28%

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 Internal return rate: advantages

The advantage is that it shows the return on the original

money invested.

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 Internal return rate: Disadvantages

At times, it can give you conflicting answers when

compared to NPV for mutually exclusive projects.
The 'multiple IRR problem' can also be an issue.

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 One-Period Rate of Return

We consider methods of calculating the return of a fund

over a 1-period interval.

We assume that the exact amounts of fund withdrawals

and injections are known, as well as the time of their
occurrence.

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 One-Period Rate of Return

Consider a 1-year period with initial fund amount B0.

Cash flow of amount Cj occurs at time tj (in fraction of a
year) for j = 1, · · · , n, where 0 < t1 < · · · < tn < 1.
Note that Cj are usually fund redemptions (withdrawals )
and new investments, and do not include investment
incomes such as dividends and coupon payments.

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 One-Period Rate of Return

Let us denote the fund value before and after the

transaction at time tj by BAj and BBj respectively, we have
BAj = BBj + Cj for j = 1,….,n.

The difference between BBj and BAj-1, i.e., the balance

before the transaction at time tj and after the transaction
at time tj-1, is due to investment incomes, as well as capital
gains and losses.

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One-Period Rate of Return

The first

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 Time-Weighted Interest Rate

The time-weighted rate of return is a measure of the

compound rate of growth in a portfolio.
Because this method eliminates the distorting effects
created by inflows of new money, it is used to compare the
returns of investment managers.
This is also called the "geometric mean return," as the
reinvestment is captured by using the geometric total and
mean, rather than the arithmetic total and mean.

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 Computing Time-Weighted Interest Rate

First calculate the return over each subinterval between

the occurrences of transactions by comparing the fund
balances just before the new transaction to the fund
balance just after the last transaction.

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 Time-Weighted Interest Rate : Example

Suppose that an investor makes a series of payments and

withdrawals, as follows:

Compute the time-weighted rate of return.

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Time-Weighted Interest Rate : Example

The first

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 Money-weighted rate of interest

Money-weighted rate of interest uses the information of

the amounts of the withdrawals and injections, as well as
their time of occurrence.
In principle, when cash of amount Cj is injected
(withdrawn) at time tj , there is a gain (loss) of capital of
amount Cj(1 − tj) for the remaining period of the year.
Thus, the effective capital of the fund over the 1-year
period, denoted by B, is given by :

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 Money-weighted rate of interest

The money-weighted rate of interest over the 1-year

period, denoted by RD, is :

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 Money-weighted rate of interest : Example

On January 1, a fund was valued at 100k (1k = 1,000). On

May 1, the fund increased in value to 112k and 30k of new
principal was injected. On November 1, the fund value
dropped to 125k, and 42k was withdrawn.
At the end of the year, the fund was worth 100k.
Calculate the DWRR and the TWRR.

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Money-weighted rate of interest : Example

The money-weighted rate of interest :

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Money-weighted rate of interest : Example

The time-weighted rate of interest :

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