Chapter 4

The Investment Decision

MakingProcess
Chapter Summary
• Time Value of Money

• Compounding and Discounting

• Annuities and Perpetuities

• Cost of Capital

• Capital investment appraisal

• Investment Appraisal Techniques

- Payback Period
- Accounting Rate of Return (ARR)
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Modified Internal Rate of Return (MIRR)
- Discounted Payback Period

• Post Completion Audit (PCA)

2
Time Value of Money
The time value of money is the greater benefit of receiving money now rather than an identical
sum later. In simple terms, money received today is worth more than the same sum received in the
future.

For example, if offered the choice between a certain sum of $100 now or the expectation of $100 in a
year's time, then most people will prefer $100 now.

There are three main reasons for the time value of money.

• Consumption preferences
• There is a strong preference for the immediate rather than delayed consumption. Investors
would typically prefer to receive returns sooner rather than later. They may even be willing to
receive smaller returns now.

• Impact of infl ation

• In most countries, in most years, prices rise as a result of inflation. Therefore, funds received
today will buy more than the same amount a year later, as prices will have risen in the
meantime. Funds are subject to a loss of purchasing power over time.

• Risk
• The earlier cash flows are due to be received, the more certain investors are. There is less
chance that events will prevent payment. Earlier cash flows are therefore considered to be less
risky.

3
Compounding and Discounting
Compound
A sum invested today will earn interest. Compounding calculates the future value (terminal value
of a given sum invested today for a number of years.

V= 𝒙(𝟏 + 𝒓)𝒏

V = Future value of money

X = Present Value of money
r = Interest rate
n = Time period

Discounting
Discounting performs the opposite function to compounding. Compounding finds the future value
of a sum invested now, whereas discounting considers a sum receivable in the future and
establishes its equivalent value today. This value in today’s terms is known as the Present Value
(PV).
PV= 𝑭𝑽 × 𝑫𝑪𝑭

𝟏 𝒏
DCF=
𝟏+𝒓

PV = Present value
FV = Future value
DCF = Discounting Factor
r = Interest rate
n = Time period

4
Annuities and Perpetuities
Annuities
An annuity is a constant annual cash flow for a number of years. This could also be regarded the
sum of individual DCFs related to a particular period.

When a project has equal annual cash flows, the annuity factor may be used to calculate the N PV
(and hence the IRR).

The PV of an annuity can therefore be easily found using the formula below.

Present Value= 𝑪𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 × 𝑨𝒏𝒏𝒖𝒊𝒕𝒚 𝑭𝒂𝒄𝒕𝒐𝒓 (AF)

Just as when determining a discount factor, the annuity factors (AF) can be found using annuity
tables (cumulative present value tables).

If not, the following equation can be used.

𝒏
𝟏− 𝟏
Annuity Factor=
𝒓
𝟏+𝒓

Perpetuities
A perpetuity is an annual cash flow that occurs forever. It is often described as a cash flow
continuing ‘for the foreseeable future’.

𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘
Present Value= 𝒓

5
Advanced and Delayed Annuities and Perpetuities
• Standard annuities and perpetuities give the present (T0) value since the first cash flow started at
T1.

• Annuity or perpetuity factors will discount the cash flows back to give the value one year
before the first cash flow arose in advanced cash flows.

• However, for delayed cash flows, applying the factor will find the value of the cash flows one
year before they began. To find the PV, an additional calculation is required. The value must be
discounted back to T0.

• This section will be explained in detail during live sessions.

6
Cost of Capital
There are a number of alternative terms used to refer the rate a firm should use to take account of the
time value of money.
a. Cost of capital
b. Discount rate
c. Required rate of return
Whatever term used, the rate of interest used for discounting reflects the cost of the finance that will
be tied up in the investment.

Changing discount rates

Theoretically, a company will have a constant discount rate allowing us to use discounting factor
tables that are provided. However, in reality, discount rates might change from year to year. In these
instances, we cannot use the tables that we are provided with and instead must calculate each year's
discount factor individually using the discounting formula.
𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕𝒊𝒏𝒈 𝒇𝒂𝒄𝒕𝒐𝒓 𝒐𝒇 𝒕𝒉𝒆 𝒑𝒓𝒆𝒗𝒊𝒐𝒖𝒔 𝒚𝒆𝒂𝒓
Discounting factor =
(𝟏+𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕𝒊𝒏𝒈 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓)

T = current year
(T-1) = previous
year
Dealing with non-annual periods
In some instances we may have to deal with cash flows which are not in annual terms. For example,
costs might be paid in 6 monthly blocks. In these cases, we need to pro-rate the discount rate to match
the period of the cash flows.
𝟏
Discounting rate = { 𝟏 + 𝒊 ( )
𝒕 }−𝟏
t = How often cash flows are received

7
Capital investment appraisal
Capital investment appraisal, also known as capital budgeting is primarily a planning process which
facilitates the determination of the concerned firm's investments, both long term and short term.

The Capital Investment Process

1. Identify Objectives
2. Search for investment opportunities Creation phase
3. Identify states of nature
4. List possible outcomes
5. Measure pay offs Decision phase
6. Select investment projects
7. Obtain authorization and implement projects
8. Review capital investment decisions Implementation phase

The Capital Expenditure Committee

The Committee is usually responsible for overseeing the capital process. The
investment functions of such a committee are to
• Coordinate capital expenditure policy
• Appraise and authorize capital expenditure on specific projects
• Review actual expenditure on capital projects against the budget

In many organizations, multidisciplinary teams, or working parties are set up to investigate

individual proposals and report back to top management on their findings. Such a team might
comprise the Project engineer, Production engineer, Management accountant, Relevant specialist etc.

8
Investment Appraisal Techniques

Investment Appraisal Techniques

Techniques which take time value of Techniques which don’t take time
money into account value of money into account

Net Present Value Payback

(NPV) Period PP)

Internal Rate of Accounting Rate

Return (IRR) of Return
(ARR)

Modified Internal Rate

of Return (MIRR)

Discounted Payback
Period (DPP)

9
Payback Period
The payback period is the time taken to recover the initial investment of a project.

The quicker that an investor can recover the initial investment the quicker they can reinvest it
elsewhere and the lower the risk of this particular investment.

Decision criteria
• Compare the payback period to the company's maximum return time allowed, and if the payback
is quicker the project should be accepted.

• Faced with a choice between mutually exclusive projects, choose the project with the quickest
payback (provided it meets the company's target payback period)

Merits De-merits

Simple to understand Does not consider the time value of money

Addresses the issue of liquidity Not a measure of absolute profitability
Emphasizes the importance of cash flows during Does not consider the cash flows after the
early years payback period

Uses cash flows instead of profits

10
Accounting rate of return (ARR)
The ARR method calculates a percentage return provided by the accounting profits of the project.

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑨𝒏𝒏𝒖𝒂𝒍 𝑷𝒓𝒐𝒇𝒊𝒕

ARR =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕+𝑹𝒆𝒔𝒊𝒅𝒖𝒂𝒍 𝑽𝒂𝒍𝒖𝒆

Average investment =
𝟐

Decision criteria
• The ARR for a project may be compared with the company's target return and if higher, the
project should be accepted

• Faced with a choice of mutually exclusive investments, the project with the highest ARR should
be chosen (provided it meets the company's target return).
Merits De-merits

Simple to understand Does not consider the time value of money

Widely used and accepted Not a measure of absolute profitability

Considers the entire life of the project Considers profit, not cash flows

11
Net Present Value (NPV)
N PV is the 'difference between the sum of the projected discounted cash inflows and outflows
attributable to a capital investment or other long term project' (Official C I M A Terminology).

The N PV represents the surplus funds (after funding the investment) earned on the project. It tells us
the impact on shareholder wealth.

Decision criteria
• Any project with a positive N PV is viable
• Projects with a negative N PV are not viable
• Faced with mutually exclusive projects, choose the project with the highest N PV

NPV = Present Value of Cash inflows – Present Value of cash outflows

Merits De-merits
Considers the time value of money A complex calculation
It is an absolute measure Issues in selecting the cost of capital
Considers cash flows over profits which can be Can be difficult for non-financial managers to
subjective understand

Considers the entire life of a project

A company choosing a project with a positive
N PV would maximize shareholder wealth

12
Internal Rate of Return (IRR)
IRR is the rate of return at which the project has a N PV of zero.

Calculating IRR
1. Calculate two NPVs for the project at two different costs of capital
2. Use the following formula to find the IRR
𝑵𝑳)
I𝑹𝑹 = 𝑳 + { 𝑵𝑳 −𝑵𝑯 × (H –
L)
L = lower discounting factor
H = Higher discounting factor
NL = NP V at Lower DCF
N H = NP V at Higher DCF

Decision criteria
1. If the IRR is greater
than the cost of
capital, the project
Conceptualization
should
Suppose, in be
an accepted
investment problem, we calculate the NP V of certain cash flows at 12% to be ($97), at 10% to
2.be zero,
If the
and yet atless
IRR is 8% to be + $108.
than the cost of
Another way of expressing this is as follows.
a. Ifcapital, the project
the company's cost of capital is 12% the investor would be $97 out of pocket.
should be rejected
b. If the company's cost of capital is 10% the investor would be earning $0. 10% is also the IRR of the project.
c. If the company's cost of capital is 8% the investor would be $108 in pocket.

13
IRR of a project with even cash fl ows
Calculating IRR of a project with even cash flows for a defi nite period – Using Annuities
a. Find the cumulative discount factor
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
Annuity Factor =
𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝒂𝒔𝒉 𝒇𝒍𝒐𝒘

b. Find the life of the project (n)

c. Look along the n year row of the cumulative discount
factor until the closest value is found
d. The column in which this figure is found is the IRR

Calculating IRR of a project with even cash flows for an

indefi nite period – Using Perpetuities
A perpetuity is a cash flow continuing for the foreseeable
future.
Merits
I𝑹𝑹 =
𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝒂𝒔𝒉 𝑭𝑳𝒐𝒘 De-merits
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
Considers the time value of money A complex calculation
It is a relative measure Not an absolute measure
Considers cash flows over profits which can be Can conflict with results obtained through a
subjective N PV calculation

Considers the entire life of a project

A company choosing a project where the IRR
exceeds the cost of capital would maximize
shareholder wealth
© C hathura 14
Jayasundara
NPV or IRR?
Although N PV are IRR both widely accepted techniques which take the time value of money into
account, only N PV can be used to distinguish between two mutually exclusive projects.

Consider the two projects below. It is evident that Project A has the higher NPV, but a lower IRR.

The N PV and IRR of these projects cab be diagrammatically shown as below.

The vital piece of information here is the
Cost of Capital (10%). This is the actual
cost of financing the project. Once this is
met, a share holder would be more
interested in knowing how much in excess
would he/she be gaining as the surplus,
not at the rate at which the N PV becomes
zero.
Therefore, if N PV and IRR provide
conflicting outcomes, the decision has to be
based on the NPV.

15
Modified Internal Rate of Return (MIRR)
A more useful measure is the modified internal rate of return or MIRR.

MIRR measures the economic yield of the investment under the assumption that any cash
surpluses are reinvested at the firm’s current cost of capital.

MIRR gives a measure of the maximum cost of finance that the firm could sustain and allow the
project to remain worthwhile.
𝟏
𝑭𝒖𝒕𝒖𝒓𝒆 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘𝒔)
MI𝑹𝑹 = { 𝒓
} – 1
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔

Decision Criteria
• Consider MIRR as the return of the project. If the MIRR > Cost of Capital, the project should be
accepted.

Discounted Payback Period

One of the major criticisms of using the payback period is that it does not take into account the time
value of money.

The discounted payback technique attempts to overcome this criticism by measuring the time taken
to recover the present value of future cash inflows from a project to equal the present value of cash
outflows.

16
Post Completion Audit (PCA)
• The post-completion audit of a project provides a mechanism whereby experience gained from
current and past projects can be fed into the organization’s decision making process to aid
decisions on future projects.

• In other words, it aids organizational learning.

• A post - completion audit reviews all aspects of an ongoing project in order to assess whether it
has fulfilled its initial expectations.

• It is a forward - looking rather than a backward - looking technique.

• The task is often carried out by the Capital Expenditure Committee, or an appointed
subcommittee.

17
Merits and De-merits
Merits De-merits

If managers know in advance that projects are going It may not be possible to identify separately the costs
to be subject to a post - completion appraisal, they and benefits of any particular project
ensure that assumptions and plans for the project are
more accurate and realistic

If an appraisal is carried out before the project life It can be a time consuming and costly exercise
ends, and it is found that the benefits have been less
than expected because of management inefficiency,
then steps can be taken to improve efficiency

It might identify weaknesses in the forecasting and Post completion appraisal may lead managers to
the estimating techniques used to evaluate the becoming overcautious and risk averse
project. The discipline and quality of forecasting for
future investments can be improved

Managers may be motivated to achieve the forecast
results if they are aware of a pending post -
completion appraisal
The appraisal reveals the reliability and quality of
contractors and suppliers involved in the project
The appraisal may highlight the reasons for success
or failure in previous projects thereby providing a
learning experience for managers to aid better decision
making in the future
The strategic effects of a capital investment project
may take years to materialize and it may never be
possible to identify and quantify them correctly
There are many uncontrollable factors in long term
investments. A post completion appraisal will not help
managers change these factors in the future

18
Thankyou

19