Investment Decision

Capital Investment Decision
1
 Purpose
 Methods
2
The Investment Decision
 The objective of the corporation is to

Maximise Shareholders Wealth
 To do this we need to invest in those
projects that will give the correct rate
of return for the risk involved
 To do this we need to be able to
3
The Investment Decision
1. Identify suitable investment
opportunities
2. Decide on the best selection method
3. Identify the cash flows that will be
generated by those investments
4. Discount them at the correct cost of
capital
5. Choose the best one or ones from
those available
4
The ideal selection method will
 Select the project that maximises
shareholders wealth
 Consider all cash flows
 Discount the cash flows at the appropriate
market determined opportunity cost of capital
 Will allow managers to consider each project
independently from all others
5
Methods for evaluating projects
 Payback
 ARR, Accounting Rate of Return
 IRR. Internal rate of return is the discount
rate that will give a Net Present Value of 0.
 NPV is the Net Present Value of a stream of
cash flows discounted at the correct cost of
capital for the degree of risk inherent in
realising those cash flows
 NPV is best but what do companies use and
why?
6
The graph shows the NPV as a function of the discount rate. The NPV is positive only for
discount rates that are less than 14%, the internal rate of return (IRR). Given the cost of
capital of 10%, the project has a positive NPV of $100 million .
7
 We know that the NPV is the best method because;

 The reinvestment rate assumption
 Value additivity
 Differences in scale
 Multiple IRRs
8
 Why not IRR and does it have a use?

1. Delayed Investments
The Bonzo Dog DoDah Band are offered
USD2,000,000 today from a rich investor to
make a new vinyl LP. They calculate that they
will need three years to make the recording
and that they will have to give up earnings in
each of those years of
USD 1,000,000. Should they do it?
9
ACFL1 9
 1st question. What is the opportunity cost of capital? Say 6%

 2nd question. What is the IRR?
With a wild stabbing guess say 23.38%
+2,000,000 – 1,000,000 – 1,000,000 – 1,000,000

1.2338 (1.2338)2 (1.2338)3
- 1,999,855 = -810,504 - 656,917 - 532,434
That’s close enough
10
ACFL1 10
 But using 6% as the cost of capital
+ 2,000,000 – 1,000,000 – 1,000,000 -1,000,000

(1.06) (1.06)2 (1.06)3
-2,673,022 = -943,396 - 889,996 - 839,630
So what should they do?
Can we explain what is going on here?
11
ACFL1 11
 Value Additivity
Try working out the NPV for the following
- 1,000,000 + 350,000 +650,000 +650,000 +650,000
- 1,000,000 + 650,000 +650,000 +650,000 + 350,000

At 10%
and now combine them. What is the combined
NPV?
Answer = 787,686 and 855,509 = 1,643,195
As combined flows = 1,643,193
12
-1,000,000 + 350,000 +650,000 +650,000

+650,000
- IRR = 39%
-1,000,000 + 650,000 +650,000 +650,000 +

350,000
- IRR = 49%
- 2,000,000 + 1,000,000 +1,300,000 + 1,300,000
+1,000,000
- IRR = 43.5%
13
 Issues of scale
 What would you prefer
A return of 50 % or one of 20% ?
an NPV of 50 or an NPV of 500?
Depends for the IRR but you would prefer the higher NPV
14
Advanced Corporate Finance
 Project A with IRR of 12%

-1201 + 500 + 500 + 500
PVF 1.1200 1.2544 1.4049
PV +1201 446 399 356
Double the scale IRR still 12%
-2402 +1000 +1000 +1000
PV +2402 893 797 712
15
ACFL1 15
Figure 6.4 B&DeM
In this case, there is more than one IRR, invalidating the IRR rule. If the opportunity cost of
capital is either below 4.723% or above 19.619%, Star should make the investment.
16
 So, its NPV But……….

 Some Reasons for usage of wrong techniques.
 Managers prefer % figures => IRR, ARR
 Managers don’t understand NPV/ Complicated
Calculations.
 Payback simple to calculate.
 Short-term compensation schemes => Payback
(Levy 200 –203, Pike 1985 pg 49).
 Behavioural Factors (see later section on
Behavioural Finance!!)
 Increase in Usage of correct DCF techniques:
 Computers.
 Management Education.
17
 How do we decide when resources are constrained? We need to maximise

NPV which may mean not going for the project with the highest NPV,
rather the combination of projects that gives the highest total NPV.
 Why would resources be constrained?
This could be due to Capital Rationing
18
ACFL1 18
 150million to invest
 Three projects
Project NPV Investment PI*
A 100 125 .80
B 80 75 1.07
C 70 75 .93
*PI = Profitability Index = Value Created
Resource Consumed
19
ACFL1 19
Capital investment Decision
 What about other scarce resources?
 E.g. bright Bath Students
20
 Profitability Index
= Value created = NPV
Resource consumed RC
Project NPV Bath Headcount
Students PI
A 30 100 .3
B 35 150 .23
C 20 70 .28
D 15 80 .18
E 12 28 .43
21
A mere 200 students are available
Project NPV Headcount Headcount Cumulative

PI requirement
E 12 28 .42 28
A 30 100 .30 128
C 20 70 .28 198
B 35 150 .23 Broken
the
budget
D 15 80 .18 22
 Try this one

380 tonnes of scarce
material
Project NPV Mats Usage Mats PI

A 50 180
B 20 70
C 45 120
D 15 75
E 35 100 23
 What do you notice?
 So?
Now Moving on
24
 Remember
We have to look at all the relevant, incremental cash
flows
- Taxes/tax losses
- Opportunity costs
- Depreciation
- Working capital
- Cannibalisation
25
Illustrations using examples from B&DeM

 New project, units 100,000 pa at 260 per
unit = 26 million
 Cost of production is 110 per unit = 11M
 Gross profit 15 million pa
 Operating expenses = 2.8 million pa
 5 million to be spent on design and
engineering
 10 million on software
 7.5 million equipment depreciated over 5
years on straight line basis
26
27
 Points to make so far

1 Tax losses
2 Depreciation
3 Interest cost
Now
Opportunity cost
28
 New lab will be housed in existing space. What should

the cost be?
 Well what are the alternative uses?
 Suppose could rent for 200,000 pa for years 1 to 4 then
this is a foregone income of 200,000 x (1-.4)
29
 Cannibalisation
25 % of the sales of the new product will come from
existing sales of a similar product. How do we account
for this?
Lost revenue at price of 100 per unit
100,000 x .25 x 100 = 2,500,000
But there will be lower cost of sales
100,000 x .25 x 60 (cost per unit) = 1.5 m
30
 Table 7.2 HomeNet’s Incremental Earnings Forecast Including Cannibalization and
Lost Rent
31
 Need to work out the Free Cash Flow

i.e. the effect of the project on the company’s cash.
 So far looked at sales and costs just need to add a
couple of things in.
1. Depreciation (which you are already familiar with
2. Net working capital
32
Capital investment Decision
Table 7.3 Calculation of HomeNet’s Free Cash Flow (Including
Cannibalization and Lost Rent)
33
Table 7.5 Computing HomeNet’s NPV (Spreadsheet)
34
 Anything else?
 Timing of cash flows
 Liquidation/salvage value
 Terminal Value
- multiple
- constant growth
35
Terminal value
 Constant Growth
1) Year 5 free cash flow is 3,000,000.
If cost of capital is 10% then PV at end year 5 of
future cash flows is
3,000,000 = 30,000,000
.10
2) Suppose expect to grow at 3% pa thereafter

Then PV at end year five of future cash flows is
3,000,000 = 42,857,143
.10 - .03
36
 Break even analysis

Using the IRR to give a feel for the ‘margin of safety’ ref
the cost of capital
 Sensitivity analysis
 Scenario analysis
37
Sensitivity Analysis
Table 7.9 Best- and Worst-Case Parameter Assumptions for HomeNet
38
Figure 7.1 HomeNet’s NPV Under Best- and Worst-Case Parameter
Assumptions
Green bars show the

change in NPV under
the best-case
assumption for each
parameter; red bars
show the change
under the worst-case
assumption. Also
shown are the break-
even levels for each
parameter. Under the
initial assumptions,
HomeNet’s NPV is
$5.0 million. 39
Scenario Analysis
40
Figure 7.2 Price and Volume Combinations for HomeNet with
Equivalent NPV
The graph shows alternative price per unit and annual volume combinations that lead to an
NPV of $5.0 million. Pricing strategies with combinations above this line will lead to a higher
NPV and are superior. 41
 Summary
 Investments should add to shareholder wealth
 NPV is the correct method
 Incremental free cash flows
 Forecasting cash flows
42
 Before moving on to other aspects of using the NPV approach we should

consider EVA or Economic Value Added.
‘The cash flows of a project less a capital charge that reflects the
opportunity cost of the capital invested as well as any capital consumed’
How does it differ from NPV?
43
ACFL1 43
 Basically NPV gives the return of a project over a period of time while EVA
focuses more on the individual time segments within the overall period
but will give the same result
44
ACFL1 44
Project NPV Mats PI Tonnes Cumulative

tonnes used
(NPV per T) Used
C 45 .375 120 120
E 35 .35 100 220

B 20 .286 70 290
A 50 .277 180 470

D 15 .200 75 -
45

Investment Decision

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Capital Investment Decision

 The objective of the corporation is to

 We know that the NPV is the best method because;

 Why not IRR and does it have a use?

 1st question. What is the opportunity cost of capital? Say 6%

+2,000,000 – 1,000,000 – 1,000,000 – 1,000,000

 But using 6% as the cost of capital

+ 2,000,000 – 1,000,000 – 1,000,000 -1,000,000

So what should they do?

Can we explain what is going on here?

- 1,000,000 + 350,000 +650,000 +650,000 +650,000

- 1,000,000 + 650,000 +650,000 +650,000 + 350,000

-1,000,000 + 350,000 +650,000 +650,000

-1,000,000 + 650,000 +650,000 +650,000 +

 Project A with IRR of 12%

 So, its NPV But……….

 How do we decide when resources are constrained? We need to maximise

A mere 200 students are available

Project NPV Headcount Headcount Cumulative

 Try this one

Project NPV Mats Usage Mats PI

 What do you notice?

Illustrations using examples from B&DeM

 Points to make so far

 New lab will be housed in existing space. What should

 Need to work out the Free Cash Flow

Table 7.5 Computing HomeNet’s NPV (Spreadsheet)

2) Suppose expect to grow at 3% pa thereafter

 Break even analysis

Table 7.9 Best- and Worst-Case Parameter Assumptions for HomeNet

Green bars show the

 Before moving on to other aspects of using the NPV approach we should

Project NPV Mats PI Tonnes Cumulative

E 35 .35 100 220

A 50 .277 180 470

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