STRATEGIC ASSET ALLOCATION

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 Understanding impact
• What will be the probable impact on Share price if company
changes its inventory valuation policy from LIFO to FIFO or
vice-versa?
• What will be the priority: Cash Vs Profitability?

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 APPLICATION
The current ratio is 2 : 1. State giving reasons which of the
following transactions would improve, reduce and not change
the current ratio:
(a) Payment of current liability;
(b) Purchased goods on credit;
(c) Sale of a Computer (Book value: Rs. 4,000) for Rs. 3,000 only;
(d) Sale of merchandise (goods) costing Rs. 10,000 for Rs. 11,000;
(e) Payment of dividend.
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 DU PONT ANALYSIS

= NPM x ASSET TO x Equity Multiplier

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 Pre-Requisite
• Time Value of Money
• Annuity
• Cost of Capital
• P&L Structure

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 Manager’s Dilemma
• Making Choice among infinite options
• Evaluate the options
• Justify the options
• Make a decision

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INVESTMENT CRITERIA

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 What are the criteria….
• NPV
• IRR
• Payback
• Profitability Index

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 Good Decision Criteria
We need to ask ourselves…….
• Does the decision rule adjust for the time value of money?
• Does the decision rule adjust for risk?
• Does the decision rule provide information on whether we are
creating value for the firm?

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 Net Present Value (NPV)
• The difference between the market value of a project and its cost
• How much value is created from undertaking an investment?
– The first step is to estimate the expected future cash flows (CF).
– The second step is to estimate the required return for projects of this
risk level (r).
– The third step is to find the present value of the cash flows and
subtract the initial investment.

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 NPV formula

n
NPV  
CFt
t
t 0 (1 r )

NPV   CF0 
CF 1

CF2
 ..... 
CF n
1 2 n
(1 r ) (1 r ) (1 r )

NPV = - (Cost of Investment) + PV(Cash flows)

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 NPV Decision Rule
If the NPV is positive, accept the project
• A positive NPV means that the project is expected to add value
to the firm and will therefore increase the wealth of the
owners.
• Since our goal is to increase owner wealth, NPV is a direct
measure of how well this project will meet our goal.

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 Project Example Information
• You are looking at a new project and you have estimated the
following cash flows:
• Year 0: CF = -165,000
• Year 1: CF = 63,120;
• Year 2: CF = 70,800;
• Year 3: CF= 91,080;
• Your cost of capital for assets of this risk is 12%.

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 Decision Criteria Test - NPV
• Does the NPV rule account for the time value of money?
• Does the NPV rule account for the risk of the cash flows?
• Does the NPV rule provide an indication about the increase in
value?
• Should we consider the NPV rule for our primary decision
criteria?

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 NPV Profile For The Project
70,000
60,000
50,000
40,000
IRR = 16.13%
30,000
NPV

20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

-20,000
Discount Rate

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 Solve It

• IRR/NPV. If the opportunity cost of capital is 11 percent, which of these

projects is worth pursuing?
• Mutually Exclusive Investments. Suppose that you can choose only one
of these projects. Which would you choose? The discount rate is still 11
percent.
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 Internal Rate of Return (IRR)
• This is the most important alternative to NPV
• It is based entirely on the estimated cash flows and is
independent of interest rates found elsewhere
• Definition:
– IRR is the return that makes the NPV = 0
• Decision Rule: Accept the project if the IRR is greater than the
cost of capital

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 IRR formula


CF 1

CF 2
 ..... 
CF n
CF0 1 2 n
(1 IRR) (1 IRR) (1 IRR)

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IRR For The Project with Constant Cash Flow
Example: A project has the following Cash Flows:
• Year 0 = -$994.76, Year 1-3 = $400, Calculate the IRR.

400 400 400

994.76  1
 2
 3
(1 IRR ) (1 IRR ) (1 IRR )

Annuity: PV = C*PVIFA(r%,t)

994.76 = 400*PVIFA(IRR%, 3)

2.4869 = PVIFA(IRR%,3)

From Appendix : IRR =10%

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 IRR: Example
• Consider the Project
$50 $100 $150

0 1 2 3
-$200

$50 $100 $150

NPV  0  200   
(1  IRR ) (1  IRR ) (1  IRR )
2 3

The internal rate of return for this project is 19.44%

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 Solve It

• Which project would you choose if the opportunity cost of

capital were 16 percent?
• What are the internal rates of return on projects A and B?

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 Solve It
A project that costs $3,000 to install will provide annual cash
flows of $800 for each of the next 6 years. Is this project
worth pursuing if the discount rate is 10 percent? How high
can the discount rate be before you would reject the project?

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 Advantages of IRR
• Knowing a return is intuitively appealing
• It is a simple way to communicate the value of a project to
someone who doesn’t know all the estimation details
• If the IRR is high enough, you may not need to estimate a
required return, which is often a difficult task

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 Internal Rate of Return (IRR)
Disadvantages:
• Does not distinguish between investing and borrowing
• IRR may not exist, or there may be multiple IRRs
• Problems with mutually exclusive investments

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 Multiple IRRs
There are two IRRs for this project:
$200 Which one should
$800 we use?
0 1 2 3
-$200 - $800
NPV

$100.00

$50.00 100% = IRR2

$0.00
-50% 0% 50% 100% 150% 200%
($50.00) Discount rate

($100.00) 0% = IRR1

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 Mutually Exclusive vs. Independent
• Mutually Exclusive Projects: only ONE of several potential projects can
be chosen, e.g., acquiring an accounting system.
– RANK all alternatives, and select the best one.

• Independent Projects: accepting or rejecting one project does not affect

the decision of the other projects.
– Must exceed a MINIMUM acceptance criteria

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 Drawing NPV profiles

NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%
.. S
10 L
. .
IRRS = 23.6%
0 . Discount Rate (%)
5 10 15 20 23.6
-10
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 Comparing the NPV and IRR methods

• If projects are independent, the two

methods always lead to the same
accept/reject decisions.
• If projects are mutually exclusive …
– If WACC > crossover rate, the methods lead
to the same decision and there is no conflict.
– If WACC < crossover rate, the methods lead
to different accept/reject decisions.

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 Calculating MIRR

0 1 2 3
10%

-100.0 10.0 60.0 80.0

10% 66.0
10% 12.1

MIRR = 16.5% 158.1

-100.0 $158.1
$100 = TV inflows
(1 + MIRRL)3
PV outflows
MIRRL = 16.5%

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 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.

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 Profitability Index (PI)
• Measures the benefit per unit cost, based on
the time value of money
• A profitability index of 1.1 implies that for
every $1 of investment, we create an
additional $0.10 in value
• This measure can be very useful in situations
where we have limited capital
• Decision Rule: Accept the project if the PI
greater than 1 (implies NPV is positive)

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 PI (contd.)

Total PV of Future Cash Flows

PI 
Initial Investent

• Minimum Acceptance Criteria:

– Accept if PI > 1

• Ranking Criteria:
– Select alternative with highest PI

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 NPV versus IRR
• NPV and IRR will generally give the same decision.
• Exceptions:
– Non-conventional cash flows – cash flow signs change more than
once
– Mutually exclusive projects
• Initial investments are substantially different
• Timing of cash flows is substantially different

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 Conflicts Between NPV and IRR
• NPV directly measures the increase in value to the firm
• Whenever there is a conflict between NPV and another
decision rule, you should always use NPV
• IRR is unreliable in the following situations
– Non-conventional cash flows
– Mutually exclusive projects

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 Payback Criteria
• Payback period
– Length of time until initial investment is recovered
– Take the project if it pays back in some specified period
– Doesn’t account for time value of money, and there is an arbitrary cutoff period
• Discounted payback period
– Length of time until initial investment is recovered on a discounted basis
– Take the project if it pays back in some specified period
– There is an arbitrary cutoff period

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 Solve It
A project that costs $2,500 to install will provide annual cash
flows of $600 for the next 6 years. The firm accepts projects with
payback periods of less than 5 years. Will the project be
accepted? Should this project be pursued if the discount rate is 2
percent? What if the discount rate is 12 percent? Will the firm’s
decision change as the discount rate changes?

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 Solve It
A proposed nuclear power plant will cost $2.2 billion to build and
then will produce cash flows of $300 million a year for 15 years.
After that period (in Year 15), it must be decommissioned at a
cost of $900 million. What is project NPV if the discount rate is 6
percent? What if it is 16 percent?

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 Solve It
What is the profitability index of a project that costs $10,000 and
provides cash flows of $3,000 in Years 1 and 2 and $5,000 in
Years 3 and 4? The discount rate is 10 percent.

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 So…what is the decision?

1. Payback Period Reject

2. Net Present Value Accept
4. Internal Rate of Return Accept
5. Profitability Index Accept

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 The Practice of Capital Budgeting
• Varies by industry:
– Some firms use payback, others use accounting rate of return.
• The most frequently used technique for large corporations is
IRR or NPV.

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CAPITAL INVESTMENT DECISION

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 Capital Investment Project
Stand Alone Principle
• It’s cumbersome to calculate the value of a firm with a project and
without a project
• Stand alone principle says – a projects can be treated as mini firm with
its own revenue and its principle

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 Identification of Relevant Cash flow
Relevant Cash flow
• Sunk Cost – Not to consider
• Opportunity cost – Yes to consider
• Side Effects – Like Cannibalization of sales or leverage of new
product (Yes)
• Net Working capital – Yes
• Capex – Yes
• Finance cost - No
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Types of Cash Flow Elements in Project
Analysis
Differential or incremental cash flow: cash flow due asset

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Cash Flows from Operating Activities
Approach 1 Approach 2
Income Statement Approach Direct Cash Flow Approach
Operating revenues Operating revenues
Cost of goods sold - Cost of goods sold
Depreciation
Operating expenses - Operating expenses
Interest expenses - Interest expenses
Taxable income
Income taxes - Income taxes
Net income Cash flow from operation
+ Depreciation

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 A Typical Format used for Presenting
Free Cash Flow Statement
Cash flow statement
Operating
+ Net income
activities
+Depreciation
Income statement
Revenues -Capital investment +
Expenses + Proceeds from sales of
Cost of goods sold depreciable assets
Depreciation - Gains tax Investing
Debt interest - Investments in working activities
Operating expenses capital
Taxable income + Working capital recovery +
Income taxes
Net income + Borrowed funds Financing
-Repayment of principal activities

Net cash flow

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When Projects Require only Operating and Investing
Activities
• Project Nature: Installation of a new computer control system
• Financial Data:
– Investment: $125,000
– Project life: 5 years
– Working capital investment: $23,331
– Salvage value: $50,000
– Annual labor savings: $100,000
– Annual additional expenses:
• Labor: $20,000
• Material: $12,000
• Overhead: $8,000
– Depreciation Method: 7-year MACRS
– Income tax rate: 40%
– MARR: 15%

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 Questions
• (a) Develop the project’s cash flows over its
project life.

• (b) Is this project justifiable at a MARR of

15%?

• (c) What is the internal rate of return of this

project?

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When Projects Require Working Capital
Investments
Working capital means the
amount carried in cash,
accounts receivable, and
inventory that is available to
meet day-to-day operating
needs.
How to treat working capital
investments: just like a capital
expenditure except that no
depreciation is allowed.

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• (a) Step 1: Depreciation Calculation

– Cost Base = $125,000

– Recovery Period = 7-year MACRS
MACRS Depreciation Allowed
N Rate Amount Depreciation Amount
1 14.29% $17,863 $17,863
2 24.49% $30,613 $30,613
3 17.49% $21,863 $21,863
4 12.49% $15,613 $15,613
5 8.93% $11,150 $5,575
6 8.92% $11,150 0
7 8.93% $11,150 0
8 4.46% $5,575 0

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 (a) Step 2: Gains (Losses) associated with
Asset Disposal
• Salvage value = $50,000
• Book Value (year 5) = Cost Base – Total Depreciation
= $125,000 - $ 91,525
= $ 33,475
• Taxable gains = Salvage Value – Book Value
= $50,000 - $ 33,475
= $16,525
• Gains taxes = (Taxable Gains)(Tax Rate)
= $16,525 (0.40)
= $6,610

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 Step 3 – Create an Income Statement
Income Statement 0 1 2 3 4 5

Revenues $100,00 $100,00 $100,00 $100,00 $100,00

0 0 0 0 0
Expenses:
Labor 20,000 20,000 20,000 20,000 20,000
Material 12,000 12,000 12,000 12,000 12,000
Overhead 8,000 8,000 8,000 8,000 8,000
Depreciation 17,863 30,613 21,863 15,613 5,581
Taxable Income $42,137 $29,387 $38,137 $44,387 $54,419
Income Taxes (40%) 16,855 11,755 15,255 17,755 21,768
Net Income $25,282 $17,632 $22,882 $26,632 $32,651

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 Step 4 – Develop a Cash Flow Statement
Cash Flow Statement 0 1 2 3 4 5

Operating Activities:

Net Income $25,282 $17,63 $22,88 $26,63 $32,651

2 2 2
Depreciation 17,863 30,613 21,863 15,613 5,581

Investment Activities:

Investment (125,000)

Working capital (23,331) 23,331

Salvage 50,000

Gains Tax (6,613)

Net Cash Flow ($148,331) $43,145 $48,245 $44,745 $42,245 $104,950

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PROJECT ANALYSIS & EVALUATION

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 Error in Estimation
• Who has seen future ?
• Projected Vs. Actual Cash flow
• What is source of value
• Forecasting risk

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 Break Even Analysis
• Sales Price – P
• Sold Quantity – Q
• Variable Cost / Unit– VC
• Fixed Cost – FC
• Contribution / Unit = (P-VC)
• Contribution Margin = (P-VC) x Q
• Profit = (P-VC) x Q – FC
• Cash Break Even (Qty) = FC/ (P-VC)
• Accounting BE Qty = (FC +Depri)/ (P-VC)
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 Degree of Operating Leverage
(DOL) Which means how much operating cash flow is committed
to the Fixed cost.
% Change in Operating Cash flow = DOL x % change in Q
Or
DOL = 1 + FC / OCF
Hi DOL – Capital intensive and low DOL means fixed cost is lower
….

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 What If analysis
What if
• Base case
• Worst case
• Best Case

Sensitivity
% change in output / % change in input

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 Manager’s Role
• Stakeholder management
• Maximization of shareholders wealth
• Value creation for Shareholder(s)

Agency Problem – “Conflict of Interest” between

Management and shareholders.

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 Control and Incentives
Control
• Board is appointed on behalf of shareholders to control
management or executives
• Audit and corporate governance
Incentive based on
• Profit
• Revenue
• Shareholder’s Value
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THANK YOU

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