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Investment decision
• Every possible method for evaluating projects impacts the flow of
cash about the company as follows.
Cash
INVESTMENT APPRAISALS
Investment
(Project X)
Financial
Manager
Invest
Dr. Nguyen Quynh Tho
Investment
(financial assets)
Shareholders
Alternative: Pay
dividend to
shareholders
Shareholders
invest for
themselves
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Investment decision
Investment decision
Investing Activities:
– Decisions that a business makes with relation to investing in real
Using the funds (capital) of the company for the acquisition of resources (assets) with the intention
assets (e.g. land, buildings, machinery, equipment) as well as
of using them to generate wealth. (Note: these resources are not held for immediate resale).
financial assets (e.g. shares, bonds)
Acquisition may be through purchase or creation of resources.
• Management of risk is crucial in these decisions
 Investment involves making an outlay of something of economic value, usually cash, at one point
• Use of sophisticated investment appraisal techniques
in time, which is expected to yield economic benefits to the investor at some other point in time.
 The outlay is typically a single large amount while the benefits arrive as series of smaller amounts
over a fairly protracted period.
 The essential feature of investment decisions is time.
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Example of Investment decision
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Key questions for the investment decision
• What is the scale of the investment?
• New product development
• Can the company afford it?
• Replacement or maintenance of equipment or buildings
• How long before the investment starts yielding returns?
• Research and development
• How long before the investment is paid back?
• Environmental protection investments (e.g. installation of
appropriate devices)
• What are the expected profits from the investment?
• Could the money invested produce a higher return elsewhere?
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Investment appraisal
Investment appraisal techniques
Investment Appraisal (also called capital budgeting) is the process by
which an organization evaluates a range of different investment
projects with a view to determining which is likely to give the highest
financial return.
Investment
Appraisal
Techniques
Ignore the time
value of money
Consider the time
value of money
(non-discounting
criteria)
(discounting
criteria)
Accounting Rate of
Return (ARR);
linked to
profitability
Payback Period
(PP)
Net Present Value
(NPV);
Internal Rate of
Return (IRR);
linked to cash
flows
linked to cash
flows
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Investment appraisal techniques: Infomation needed
CFO Decision Tools
• Cash Outflows:
– Initial investment
– Delivery and installation of asset
– Increase of working capital commitment
Survey Data on CFO Use of Investment Evaluation Techniques
• Cash Inflows:
– Contribution from sales of product (service)
– Cash from sale of equipment replaced
– Scrap value of an asset
– Reduction in working capital at the end of the project’s life
SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 61 ( 2001), pp. 187-243.
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NPV RULE
NET PRESENT VALUE (NPV)
Net present value (NPV) is the difference between the present value
of cash inflows and the present value of cash outflows.
 All projects which have a positive NPV should be accepted
while those that are negative should be rejected.
NPV = PV of all expected cash inflows and cash outflows
 If funds are limited and all positive NPV projects cannot be
initiated, those with the high discounted value should be
accepted.
NPV compares the value of a dollar today to the
value of that same dollar in the future, taking
inflation and returns into account.
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What is the appropriate discount rate?
Finding the cost of capital
 Project cashflows can only be estimated, rather than known.
The proposed investment should provid at least the rate of
return we can obtain by alternative investments of similar
risk found in the financial markets.
 The discount rate equals the (opportunity) cost of capital, i.e.
hurdle rate.
 The discount rate depends to the risk of the firm, generally,
as well as the risk of the project.
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Practice Example 1
Practice Example 2
Suppose that your firm is considering whether to launch a new
Suppose that Super Ltd. Has the following two projects:
product which requires an initial investment of $50,000 for
Year
Project A
Project B
working machines and raw materials. Your firm expects to get the
0
-$20,000
-$24,000
sale of $5,650 per year for 15 years with first payment occurring 1
1
$13,200
$14,100
year from now. If the appropriate discount rate is 8%, would you,
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$8,300
$9,800
as the CFO, accept the project? What if after the first year, the
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$3,200
$7,600
cash flow from this project will increase by 4% per year?
Which project Super Ltd. should invest? Suppose that the two projects
have the same required rate of return at 15%
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Practice Example 3
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Strengths of the NPV
The CityU corporation wants to set up a new factory in Hanoi. According to the
The NPV is a powerful investment appraisal method as it takes
CFO, Harry Potter, the net cash inflow from this factory is $315,000 for the firm
under consideration:
during the first year, and the cash flows are projected to grow at a rate of 4.5%
 All expected future cash flows of the investment
per year forever. The project requires an initial investment of $4,100,000.
 The timing of these cash flows
1. Would the firm accept the project? Suppose that the discount rate is 10%.
2. The board of director is unsure about CFO’s assumption of 4.5% growth rate.
 The risk of the investment
 The shareholder wealth maximization objective: the value
At which growth rate would the firm being break-even with this project?
of the firm rises by the NPV of the project
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Capital rationing
NPV with capital rationing
A firm is limited to spending $10 million for investments and is faced
A firm should accept all available investments that
with the following three opportunities:
result to a positive NPV.
Cash flows ($ millions)
Project
CF0
CF1
What happens in the case of capital rationing, that is,
A
-10
when there is limited amount of money to invest?
B
-5
C
-5
NPV
CF2
R = 10%
+30
+5
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+5
+20
16
+5
+15
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Profitability Index
Comments on the profitability index
The profitability index rule is a variation of the NPV rule.
if NPV > 0, the PI > 1
if NPV < 0, the PI < 1
 calculations of PI and NPV would both lead to the same decision
A profitability index attempts to identify the relationship between
the costs and benefits of a proposed project.
The PI ratio =
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PV of Future Cash Flows
Initial Investment
 PI ignores the scale of investment and provides no indication of the
size of the actual cash flows.
PI > 1  profitability is positive
PI < 1  the project's PV is less than the initial investment  the
project should be rejected or abandoned.
 PI selects the projects that produce the “biggest bang for each
investment buck”
Profitability index rule: PI must be greater than 1.0 for the project
to proceed.
 PI can be misleading when used to choose between mutually
exclusive projects.
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Capital rationing
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Investment appraisal techniques
• Funds are not available to finance all wealth-enhancing projects
Investment
Appraisal
Techniques
• Soft rationing (internal restrictions)
• Hard rationing (external restrictions)
• One-period rationing
• Multi-period rationing
• Divisible projects
• Indivisible projects
Ignore the time
value of money
Consider the time
value of money
(non-discounting
criteria)
(discounting
criteria)
Accounting Rate of
Return (ARR);
linked to
profitability
Payback Period
(PP)
Net Present Value
(NPV);
Internal Rate of
Return (IRR);
linked to cash
flows
linked to cash
flows
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IRR RULE
Internal rate of return (IRR)
 The IRR is the interest rate (also known as the discount rate) that will
bring a series of cash flows to a net present value (NPV) of zero.
• Project must meet a minimum IRR requirement (The opportunity
 The IRR formula can be very complex depending on the timing and
variances in cash flow amounts. Without a computer or financial
calculator, IRR can only be computed by trial and error.
• If competing projects exceed minimum IRR requirement, the one
N
NPV  
n 1
cost of finance).
with the highest IRR is selected.
• If
CFn
0
(1  IRR) n
– IRR > discount rate => invest in project
– IRR < discount rate => invest in alternative
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Practice example
IRR CALCULATIONS
Cash flows ($ millions)
• IRR cannot usually be calculated directly.
• Iteration (trial and error) is the approach normally adopted.
• It requires the calculation of two (2) different NPV values for
the same project, one positive and one negative, i.e. it requires
the use of at least two different discount rates.
• Doing this manually is fairly laborious, so we use spreadsheet
packages.
Project
CF0
CF1
CF2
NPV @ 10%
A
-10
+30
+5
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B
-5
+5
+20
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C
-5
+5
+15
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D
0
-40
+60
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IRR
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Pitfalls of the IRR
Strengths of IRR
IRR pitfall 1: Lending or Borrowing?
Similarly to the NPV, the IRR takes under consideration:
Not all cash-flow streams have NPVs that decline as the discount rate increases.
 All expected future cash flows of the investment
Consider the following projects A and B:
 The timing of these cash flows
Project
C0
C1
IRR NPV @10%
A
 1,000  1,500  50%
 364
B
 1,000  1,500  50%
 364
 The risk of the investment
 The shareholder wealth maximization objective
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Pitfalls of the IRR
Pitfalls of the IRR
IRR pitfall 1: Lending or Borrowing?
IRR pitfall 2: Multiple rates of return
Not all cash-flow streams have NPVs that decline as the discount rate increases.
Certain cash flows can generate NPV = 0 at two different discount rates
Consider the following projects A and B:
Helmsley Iron is proposing to develop a new strip mine in Western Australia. The mine
involves an initial investment of A$30 billion and is expected to produce a cash inflow
Project
C0
C1
IRR NPV @10%
A
 1,000  1,500  50%
 364
B
 1,000  1,500  50%
 364
of A$10 billion a year for the next 9 years. At the end of that time the company will incur
A$65 billion of cleanup costs. Thus the cash flows from the project are:
o In the case of A, where we are initially paying out $1,000, we are lending money at
50%  we want a high rate of return
o In the case of B, where we are initially receiving $1,000, we are borrowing money at
50%  we want a low rate of return.
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Pitfalls of the IRR
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Pitfalls of the IRR
IRR pitfall 2: Multiple rates of return
IRR pitfall 2: Multiple rates of return
Certain cash flows can generate NPV = 0 at two different discount rates
IRR1 = 3.5%
IRR2 = 19.54%
The reason for this is the double change in the sign of the cash-flow stream.
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Pitfalls of the IRR
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Pitfalls of the IRR
IRR pitfall 2: Multiple rates of return
IRR pitfall 2: Multiple rates of return
There are also cases in which no IRR exists.
Project
C0
C1
C2
IRR NPV @10%
C
 1,000  3,000  2,500 None
 339
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Pitfalls of the IRR
Pitfalls of the IRR
IRR pitfall 3: Scale issue
IRR pitfall 3: Scale issue
IRR rule can be misleading in ranking projects of different scale.
IRR rule can be misleading in ranking projects of different scale.
IRR sometimes ignores the magnitude of the project.
 looking at the IRR on the incremental flows.
•
Project
C0
C1
IRR NPV @10%
D
 10,000  20,000 100%
 8,182
E
 20,000  35,000  75%
 11,818
First, consider the smaller project (D). It has an IRR of 100% > 10% opportunity
cost of capital  D is acceptable.
•
Second, is it worth making the additional $10,000 investment in E?
The incremental flows from undertaking E rather than D are as follows:
Consider 2 project D and E:
-
According to NPV rule  choose E
-
According to IRR rule  choose D
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Pitfalls of the IRR
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Pitfalls of the IRR
IRR pitfall 4: Mutually Exclusive Projects
IRR pitfall 4: Mutually Exclusive Projects
It is also unreliable in ranking projects that offer different patterns of cash flow
IRR rule can be misleading in ranking projects of different scale. It is also
over time.
unreliable in ranking projects that offer different patterns of cash flow over time.
Project F has a higher IRR, but project G, which is a perpetuity, has the higher NPV.
Reason: the total cash inflow of project G is larger but tends to occur later.
Therefore, when the discount rate is low, G has the higher NPV; when the discount
rate is high, F has the higher NPV.
 If you want to use IRR rule, look at the IRR of incremental flows
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Pitfalls of the IRR
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Pitfalls of the IRR
IRR pitfall 5: More than One Opportunity Cost of Capital
The most general formula for calculating net present value:
First, you check that project F has a satisfactory IRR. Then you look at the return on
the incremental cash flows from G:
The IRR on the incremental cash flows from G is 15.6%, greater than the opportunity
cost of capital  you should undertake G rather than F
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The IRR rule tells us to accept a project if the IRR is greater than the opportunity cost
of capital. But what do we do when we have several opportunity costs? Do we
compare IRR with r1, r2, r3, . . .?
we would have to compute a complex weighted average of these rates to obtain a
number comparable to IRR  too complicated!!!
Many firms use the IRR assuming that there is no difference between short-term
and long-term discount rates.
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Payback period
Investment appraisal techniques
A project’s payback period is found by counting the number of years
Investment
Appraisal
Techniques
it takes before the cumulative cash flow equals the initial investment.
Ignore the time
value of money
Consider the time
value of money
(non-discounting
criteria)
(discounting
criteria)
Accounting Rate of
Return (ARR);
linked to
profitability
Payback Period
(PP)
Net Present Value
(NPV);
Internal Rate of
Return (IRR);
linked to cash
flows
linked to cash
flows
How rapidly each project pays back its initial investment?
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Payback rule
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Comments on payback period
The payback period is a simple, straightforward and popular investment
 All other things being equal, the better investment is the one
appraisal method.
with the shorter payback period.
There are some serious shortcomings as it doesn’t consider:
 The timing of the cash flows
 Normally, a project should be accepted if its payback period is
 The cash flows beyond the payback period
less than some specified cut-off period.
 The risk of investment
 The shareholder wealth maximisation objective.
 The payback method is often used by large, sophisticated companies
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Discounted Payback
when making relatively small decisions.
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Discount payback period
We need to discount the cash flows before they compute the
Occasionally companies discount the cash flows before they compute the
payback period.
payback period.
The discounted payback rule asks, how many years does the project have to
last in order for it to make sense in terms of net present value?
 the discounted payback rule will never accept a negative-NPV project.
How rapidly each project pays back its initial investment?
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Accounting Rate of Return - ARR
ARR drawbacks
Average accounting return or accounting rate of return or ARR, is an accounting
method used for the purposes of comparison with other capital budgeting
calculations, such as NPV, PB period and IRR.
ARR = Average Profit / Average Investment
 ARR compares the amount invested to the profits earned over the course of a
project's life. The higher the ARR, the better.
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The major drawbacks of ARR are as follows:
 It uses operating profit rather than cash flows. Some capital investments have
high upkeep and maintenance costs, which bring down profit levels.
 Unlike NPV and IRR, it does not account for the time value of money. By ignoring
the time value of money, the capital investment under consideration will appear
to have a higher level of return than what will occur in reality.
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