Bachelor Grande Ecole Program

Semester 5

INVESTMENT DECISIONS
1 – Decision criteria

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Time Value of Money – Discount rates

• What is the value of the Discount rate? (compound or) discount rate

?
• A risk-free rate ()?

• Some return on investment?

• The interest rate on your loan to fund your project?

• Inflation?

As a general rule, you use as a discount rate at least the minimum acceptable return you would get if you could
invest your cash.

Think in terms of opportunity cost: if you had the cash, how would it grow?
and as a result,
what do you miss if you receive it later?

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Investment decisions

Example 1.1. (compound or) discount rate

You want to become an independent ESG consultant for firms

of your region that want to improve their CSR performance.

In order to launch your business, you don’t need to spend much: you will buy a good computer, an electric bike
to visit your clients, some business cards and a nice suit, for a total amount of €3,000. All the rest is voluntary
work, you don’t plan to pay yourself any salary until your little business becomes really profitable.

You expect that your activity will generate consulting revenues (paid cash at the end of each year by your
clients) of €1,500 the first year and €2,000 the second year. Then you’ll graduate from IESEG and start another
activity.

1) Do you think these revenues are enough to cover for your costs? Do you think it’s worth the trouble?

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Investment decisions – valuation of the investment opportunity

Example 1.1. (compound or) discount rate

2) If you could invest cash at any time on a bank account at

an interest rate for cash of 2%, what would be the future
value of your business at the end of the period?

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Investment decisions – valuation of the investment opportunity

Example 1.1. (compound or) discount rate

2) If you could invest cash at any time on a bank account at

an interest rate for cash of 2%, what would be the future
value of your business at the end of the period?

3) If you had to sell share of your mini-business today to a single investor, how much would you make them pay
for it? (they would become the owner of all future revenues)

General rule :
valuation today of a financial asset = equivalent today of every
cash flow it will generate in the future

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Investment decisions – valuation of the investment opportunity

Example 1.1. (compound or) discount rate

2) If you could invest cash at any time on a bank account at

an interest rate for cash of 2%, what would be the future
value of your business at the end of the period?

3) If you had to sell share of your mini-business today to a single investor, how much would you make them pay
for it? (they would become the owner of all future revenues)

4) Compare that amount with what it costs you to actually start that mini-business. Based on that amount, was it
worth starting the mini-business for you?

This amount is called the Net Present Value of the project

= equivalent today (for you) of the “extra” profit that will be generated in the future
by investing in this project beyond the minimum you require
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Investment decisions – valuation of the investment opportunity

Example 1.1. (compound or) discount rate

2) If you could invest cash at any time on a bank account at

an interest rate for cash of 2%, what would be the future
value of your business at the end of the period?

3) If you had to sell share of your mini-business today to a single investor, how much would you make them pay
for it? (they would become the owner of all future revenues)

4) Compare that amount with what it costs you to actually start that mini-business. Based on that amount, was it
worth starting the mini-business for you?

5) What if you “opened your capital” after 1 year? How much would you make someone pay to own your mini-
business?

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Investment decisions – valuation of the investment opportunity

Example 1.1. (compound or) discount rate

6) Imagine you meet someone who seems really interested in

your business and wants to become its single shareholder today.
If that person borrows money to buy your business (contracting a loan
on 2 years with an interest rate of 3.5% paid annually), how much would they be ready to pay?

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Investment decisions – Internal Rate of Return (IRR)

Example 1.1. (compound or) discount rate

6) Imagine you meet someone who seems really interested in

your business and wants to become its single shareholder today.
If that person borrows money to buy your business (contracting a loan
on 2 years with an interest rate of 3.5% paid annually), how much would they be ready to pay?

7) Now try to determine what annual rate of return would have given you the same wealth at the end of the 2
years if you had invested your €3,000 cash at this rate at time 0 (you can consider it as the rate another
investment should have promised to make it as interesting as launching your mini-business for you).

This rate is called the Internal Rate of Return of the project

= which rate would make [investing in the project]
as interesting as [investing at the discount rate instead]

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Investment decisions – Net Present Value (NPV)

Example 1.1. (compound or) discount rate

6) Imagine you meet someone who seems really interested in

your business and wants to become its single shareholder today.
If that person borrows money to buy your business (contracting a loan
on 2 years with an interest rate of 3.5% paid annually), how much would they be ready to pay?

7) Now try to determine what annual rate of return would have given you the same wealth at the end of the 2
years if you had invested your €3,000 cash at this rate at time 0 (you can consider it as the rate another
investment should have promised to make it as interesting as launching your mini-business for you).

8) In case that IRR was your discount rate, what would the Net Present Value of doing that business for you?

The Internal Rate of Return is the discount rate that makes NPV = 0

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Investment decisions – Net Present Value (NPV)

Example 1.1. (compound or) discount rate

6) Imagine you meet someone who seems really interested in

your business and wants to become its single shareholder today.
If that person borrows money to buy your business (contracting a loan
on 2 years with an interest rate of 3.5% paid annually), how much would they be ready to pay?

7) Now try to determine what annual rate of return would have given you the same wealth at the end of the 2
years if you had invested your €3,000 cash at this rate at time 0 (you can consider it as the rate another
investment should have promised to make it as interesting as launching your mini-business for you).

8) In case that IRR was your discount rate, what would the Net Present Value of doing that business for you?

9) Does it mean the project provides you with no ROI (return on investment)?

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Investment decisions – Highlights

Example 1.1. (compound or) discount rate

Recap. of what matters:

• discount rates can differ from one person to the other

• discount rates can relate to investment opportunities for cash

… or to the cost of getting cash (a “cost of capital” that becomes a required

return)

• the Net Present Value (NPV) of a project is [PV of cash revenues – PV of cash costs (incl. initial
investment)]

• the Net Present Value of a project depends on the discount rate (it can differ for investors and
entrepreneurs)

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Investment decisions – Highlights

Example 1.1. (compound or) discount rate

Recap. of what matters:

• if your NPV > 0 it is worth investing (according to your assessment)

• if your NPV = 0 you are indifferent between investing or not (according to your assessment)
• if your NPV < 0 it is NOT worth investing (according to your assessment)

• the Internal Rate of Return (IRR) is the discount rate that would make an entrepreneur indifferent between
investing or not

• the Internal Rate of Return (IRR) is the one that results in NPV = 0

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Investment decisions – NPV profile

Example 1.1.

In our example we calculated the following:

• for a discount rate of 2% the NPV was equal to €392.93

• for a discount rate of 10.39% the NPV was equal to €0

We can then start establishing an “NPV profile” as follows:

it shows the value of NPV depending on the discount rate
that was used to calculate it.

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Investment decisions – Link between NPV and ROI

Example 1.2. (compound or) discount rate

18%
Assume you invest €1,000 today in some stocks that
after 1 year have increased to be worth €1,100.
You did not perceive dividends.
Return generation: 10%

1) Ignore the taxes on capital gains for now, what is your return on investment?

2) Now imagine that you had to borrow money to invest in these stocks. As you didn’t have a penny and
offered no guarantee, no bank would accept to lend you money to invest in the stock market. You could only
find a loan shark who lent you the €1,000 at a nominal interest rate of 18% compounded annually.

Do you think your investment paid enough to make it worth doing the whole thing?

3) What is the NPV of your investment in stocks’ project?

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Investment decisions – Link between NPV and ROI

Example 1.2. (compound or) discount rate

18%
As long as your project generates a higher investment return than
what’s required (your discount rate), NPV will be positive.
Return generation: 10%
If your project generates a lower investment return than what’s
required (your discount rate), NPV will be negative.

So:
NPV < 0 or NPV = 0 does NOT mean that the project is bad in itself

it may very well have a positive investment return

… just not a high enough investment return compared to what you required

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Homework– Useful Excel functions

Example 1.1.

Use of Excel to calculate NPV and IRR (to be tried

at home)

Use the
Timeseries of Cash Flows
0 of Example 11.1 and report them
2 on an Excel Sheet as follows:
CFs -$ 3,000.00 $ 1,500.00 $ 2,000.00

Then, on another cell, use the Excel function for NPV (“VAN” in French, “NPV” in English)
=NPV( discount rate , [range from time 1 to last payment] )
⇒ WARNING ! It MUST ignores time 0, as the Excel “NPV” function is actually
the Present Value of all Cash Flows starting from the one at time 1, not time 0

“True” NPV = Excel NPV + cash flow at time 0

Use also the Excel function for IRR (“TRI” in French, “IRR” in English)
=IRR( [range from time 0 to last payment] , [guess] ) p. 12
Homework– Useful Excel functions

Example 1.1.

Draw an NPV profile on Excel

Then, use again the data of Example 1.1 to draw an NPV profile for discount rates that range from 1% to 25%

Steps:

- set all the possible discount rates in the 1 st column of a new table
- set the for formula for NPV of the project in each row depending on the discount rates of the 1 st column
- insert a graph (scatter plot) to visualize the NPV profile

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