FINM372

CAPITAL INVESTMENT DECISION LECTURE 3

Learning Outcomes

 Compare projects with unequal lives;

 Explain the effect of inflation on the capital budgeting decision;
 Adjust for inflation by choosing the discount rate or calculating the
future cash flows;
 Rank and evaluate projects under the conditions of capital
rationing;
 Consider the abandonment value and optimal economic lives;
 Apply the techniques used to evaluate complex capital investment
problems; and
 Consider qualitative factors in making investment decisions.
Projects With Unequal Lives
Refer to Correia 9,2 – 9,5
 So far we have assumed that all of the investment alternatives have
the same live.
 Reality is that investment alternatives can have different usefull lives.

 Methods to Evaluate which project should be accepted if the lives

are different:
1. Replacement Chains - Assumes projects can be repeated until
common period is reached (NPV)
2. Equivalent annual annuities (use TVM, your NPV will be the PV, N=
no. of years of project; I/Y= WACC; comp PMT)
3. Equivalent annual cost (similar to above, except use initial cost as
PV)
Class example

 Project A has an NPV of R25 000 and is over a period of 3 years. The
initial cost is R10 000.
 Project B has an NPV of R30 000 and runs over a period of 5 years.
The initial cost is R15 000.

 The WACC is 12%

Evaluate which project should be accepted based on:

I. Equivalent annual annuities
II. Equivalent annual cost
Equivalent annual annuities

 Project A Project B
 PV = 25 000 PV = 30 000
 N=3 N=5
 FV = 0 FV = 0
 I/Y = 12% I/Y = 12%
 Comp PMT = Comp PMT =

 Select the project with the higher PMT ( highest Equivalent annual
annuities)
Equivalent annual cost

 Project A Project B
 PV = 10 000 PV = 15 000
 N=3 N=5
 FV = 0 FV = 0
 I/Y = 12% I/Y = 12%
 Comp PMT = Comp PMT =

 Select the project with the lower PMT ( lowest Equivalent annual
cost)
Capital rationing

 Companies do not have unlimited capital available to finance

products.
 Thus some projects will need to be considered above others:
 We call this – Capital Rationing
Capital rationing

 There are two techniques that we use to determine which projects

to invest in :
1. if projects are divisible into separate independent components we
use the Profitability Index to rank the projects
2. If projects are indivisible the objective is to maximise the sum of
NPVs with selected projects
Class example

 You have R100 million available; which project/s would you select?

Project A B C D
Cost 40 30 50 26
NPV 6 6 5 4

 Required:
1. Assume the projects are divisible into separate independent
components
Assume the projects are divisible
into separate independent
components
Project A B C D
Cost 40 30 50 26
NPV 6 6 5 4
Profitability 0,15 0,20 0,10 0,153
Index

Thus invest in Projects B , D and A

Assume the projects are indivisible
You have R74 million available; which project/s would you select?

Project A B C D
Cost 40 30 50 26
NPV 6 6 5 4

Thus invest in : A and B

The 4 Mil that is not used will be reinvested

Abandonment value

• Even though a company takes a particular investment decision, it needs to

be constantly monitored and evaluated

• The calculation of an abandonment value is a tool allowing the financial

manager to determine the project’s optimal economic life
Abandonment value

What is it?

• Value given for the end of a particular period

• Used to evaluate projects that are already in motion

How to take this value into account in your evaluation:

• Calculate present value of projects remaining cash flows

• subtract abandonment value (as this is the opportunity cost of continuing

the project)
Abandonment Value
example

Basic example:

Tutti Fruitti invested in project Grape a year ago. The project was expected to
generate cash flows over 5 years. The estimated abandonment value at the end
of 2018 is R200 million. The projected and actual cash flows of the project are
as follows. The company’s cost of capital is 11%. Ignore tax for now.

Should project Grape be abandoned at the end of 2018?

Abandonment Value
example

At the end of 2018:

PV of FORECAST cash flows= R563 million
Less R200 million

Remaining Project Value= R363 million

Therefore do not abandon.
Optimal economic life

In questions thus far you have been given the useful life of potential
investments and we have not given any consideration to why the businesses
have selected those number of years.

Estimating future abandonment values of a project at the initial investment

stage is a tool allowing the financial manager to determine the project’s optimal
economic life

Calculated before the project has started

Optimal economic life
example
Basic example:

Tutti Fruitti wants to invest in project Grape. Project grape will cost R100 million
to implement at the end of 2017. The project is expected to generate cash flows
over 5 years. The estimated abandonment values at the end of each period is
given below along with the projected cash flows. The company’s cost of capital
is 11%. Ignore tax for now.

Calculate the optimal economic life of the project.

Optimal economic life example cont.
Include the abandonment value as
a cash flow in each iteration
R’million

Number of Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow NPV @ 11%
Years of end 2017 2018 2019 2020 2021
Project The optimal
economic
life is the
option that
yields the
highest NPV
4 -100 300 250 200 50+0 552,35
3 -100 300 250 200+50 555,97

2 -100 300 250+150 494,92

1 -100 300+200 350,45

Approaches to Cash Flows

Incremental approach: state clearly which perspective you are using

⚫Only cash flows that differ between alternatives
⚫One NPV calc and one tax calc

Total approach
⚫

⚫Include all costs of all alternatives

⚫Calculate NPV and tax for each alternative

⚫Difference between alternatives

Under what
circumstances is it
appropriate to use each
different method?
 Basic example: incremental vs total
approach Beans Ltd wants to mechanise their production process. The initial
investment in capital will be R10 million.
Cash flows applicable to the mechanised process:
Engineers paid R2 million per year
Annual machine maintenance of R500 000
Annual insurance on machinery R50 000

Cash flows currently achieved from labour intensive process:

Old machinery can be sold for R50 000 (or used for a further 3 years)
Let’s ignore tax for now, and only Current maintenance and insurance annual expense: R400 000
focus on the cash flows to Current labour costs of R3 million per year, this would reduce to R1,5
demonstrate the difference between million if the process is mechanised. Severance pay of R250 000 would
the approaches need to be paid to labourers laid off.
Fixed costs of R100 000 per year would be incurred by Beans Ltd regardless
of whether the production process is labour or machine intensive.
Currently 100 000kg of coffee can be produced annually, sold at R60 per kg;
if the process is mechanised: 150 000kg of coffee can be produced per year
(to be sold at the same price)
Basic example: total approach

Both options evaluated

separately

NB- these are the cash flows

excluding tax
Basic example: incremental approach

Evaluate both options using one

calculation…
This calculation is performed from the
perspective of “if you choose to
purchase the machine” NB- these are the cash flows
excluding tax
Homework

Correia question:
9,1
9,3
9,9
Question 9-15

eFundi questions:
2016 Class Test 2
2018 1st Opp exam Question 3 ONLY
2020 1st Opp exam Question 1.1