Long term decision making
Corporate Strategic Decision
1. Growth decision
Source: Ansoff Matrix (Igo Ansoff)
Financial Feasibility
• Evaluating the financial feasibility of such a
decision will ensure that share holders money
are invested in a profitable investment
opportunity.
Investment Appraisal Methods
Discounted Cash Flow Methods
Net Present Value (NPV)
Internal Rate of Return (IRR)
Non-Discounted Cash Flow
Methods
Payback Method
Accounting Rate of Return
Discounted Cash Flow Methods
NPV - the sum of discounted future cash
flows less the initial cost
IRR - the discount rate where NPV = 0
Net Present Value (NPV)
NPV =
C1
(1 + r)1
+
C2
(1 + r)2
Discounted cash flows
C1, C2, C3 = the project cash flows,
r = discount rate (related to risk of the project)
C0 = initial cost
+ C3
(1 + r)3
- C0
Initial Cost
Investment Decisions
The board of directors of Magoo plc. is considering
investing in a new machine that is expected to have a
three year life and will cost £80,000. The machine is
used to produce a good that is expected to have the
following cash flows over the three years of the
machine’s life - Year 1 = £30,000; Year 2 = £50,000; Year
3 = £40,000. Cost of capital is 8%
Should it purchase the machine?
Fundamental Rule of
Finance/Financial Economics
A capital investment decision is only
worthwhile if it adds value. Thus, invest
only in projects with a positive net
present value
Projections
• This is the most crucial part of the long term
investment decision evaluation. Accurately
forecast the cost and the revenue for given
period will have significant impact to the
decision.
Student Activity
You are the financial manager advising the board of
Alpha plc. on potential investment projects and have
the choice between two projects of the same risk
classification whose cash flows are given below:
Year
Cash flow of
Project X
Cash flow of
Project Y
0
-120,000
-80,000
1
20,000
40,000
2
60,000
40,000
3
100,000
30,000
Given that the firm
expects to obtain a
10% return on projects
of this level of risk,
provide a
recommendation to
the board on the
viability of the two
projects
INTERNAL RATE OF RETURN (IRR)
• Also based on Discounted Cash Flow, but calculates the discount
rate that will give a Net Present Value of zero.
• This also represents the return that the project is giving on the
original investment, expressed in DCF terms.
• The simplest way is to use trial and error - trying different rates
until the correct rate is found. But this is laborious.
• There is a formula, using linear interpolation.
• Projects should be accepted if their IRR is greater than the cost of
capital or hurdle rate.
IRR – Interpolation method
NL
H  L 
IRR  L 
NL  NH
o Where:
o
o
o
L is the lowest discount rate
H is the higher discount rate
NL is the NPV of the lower rate
NH is the NPV of the higher rate
NPV and IRR
Gullane plc. are considering investing in a new machine
that will cost £1 million. They estimate the machine will
lead to an increase cash flow for the next three years of
£500,000 in year 1, £600,000 in year 2, and £400,000 in
year 3.
Given that Gullane plc. determine that the risk-adjusted
cost of capital is 10%, calculate the Net Present Value of
the machine and recommend whether to ahead with the
investment or not
Calculate the Internal Rate of Return of the machine
Internal Rate of Return
Decision Rules
If k > r reject. If the opportunity cost of capital (k) is
greater than the internal rate of return (r) on a
project then the investor is better served by not
going ahead with the project and using the money to
the best alternative use
If k < r accept. Here, the project under consideration
produces the same or higher yield than investment
elsewhere for a similar risk level
Payback
•
•
•
•
Consider Cash flows and NOT Profits
Evaluation based on period of recovery of the initial investment
ie. Number of years it takes to cover the cost of investment
Firms should look for early payback of capital invested
Decision criteria
• Compare target payback with actual payback
• If actual payback period < target payback - Accept project
• If actual payback period > target payback - Reject project
15
Discount factor
• Cost of capital of firm
• Minimum rate of return, the firm must earn on its
investments
• Hence also the Required rate of return
• Also considered as Opportunity cost
• The required rate of return must cover, the cost of all
long term sources of funds
• Computed as the Weighted average cost of capital
16
Cost of capital (COC)
• Cost of capital is the company cost of long
term source of finance which is generally used
to capitalized the asset.
• There are tow major sources of long term
funds.
• Equity and Debt capital
Cost of equity
The cost of equity is the return that stockholders
require for their investment in a company. The
traditional formula for cost of equity (KE) is the
dividend capitalization model:
If the project is equity funded appropriate cost of capital is Ke
Compounding annual growth rate
(CAGR)
• The year-over-year growth rate of an variable
over a specified period of time. The
compound annual growth rate is calculated by
taking the nth root of the total percentage
growth rate, where n is the number of years in
the period being considered.
Cost of Equity
• The most commonly accepted method for calculating cost
of equity comes from the Nobel Prize-winning capital asset
pricing model (CAPM): The cost of equity is expressed
formulaically below:
• Re = rf + (rm – rf) * β
• Where:
Re = the required rate of return on equity
• rf = the risk free rate
• rm – rf = the market risk premium
• β = beta coefficient = unsystematic risk
Cost of debt
• This is the cost of borrowing , which is the
interest cost.
• Interest is tax shield
Therefore cost of debt ,
Where,
Kd= I(1-T)
Costs and benefits of debt
• Benefits of Debt
– Tax Benefits
– Adds discipline to management
• Costs of Debt
– Bankruptcy Costs
– Loss of Future Flexibility
22
Risk vs. Cost of Capital
Type of Funding
Risk to the
Provider
Cost of funds
Venture Capital Finance
Extremely High
Extremely High
Ordinary Shares
Very High
Very High
Preference Shares
High
High
Unsecured Debentures
Low
Low
Bank Loans / Secured
Debentures
Very Low
Very Low
Internal Funding
Neutral
Medium
23
Cost of Capital
Type of Funding
Cost of Capital
Equity / VC Finance
Expected Rate of Return by the future share holders to
compensate risk
Preference Shares
Fixed dividends stated in the prospectus.
Debentures
Interest Rates stated in the prospectus
Bank Loans
Commercial interest rates set in the loan agreement
Internal Funding
Current Return on Investment (ROI) of the company
Weighted Average Cost of Capital (WACC)
If more than one tool is used to finance the project , then WACC ( Weighted
Average Cost of Capital) is used to discount the project’s cash flow.
24
Weighted Average Cost Of Capital
(WACC
• Weighted average cost of capital (WACC) is a
calculation of a firm's cost of capital in which
each category of capital is proportionately
weighted. All capital sources - common stock,
preferred stock, bonds and any other long-term
debt - are included in a WACC calculation.
• All else equal, the WACC of a firm increases as
the beta and rate of return on equity increases,
as an increase in WACC notes a decrease in
valuation and a higher risk.
WACC
• Where,
WACC= KeVe + KdVd
Ve+Vd
Ke=Cost of equity
Ve=Value of equity
Vd=Value debt
Kd=Cost of debt
Target Capital Structure
Re
Cost of capital
WACC
Re
Rd
Rd
0
Target Capital
Structure
Debt-equity ratio, D/E
Assumption of WACC
• Capital structure should be reasonably
constant.
• The new investment should not carry a
significant different risk profile from the
existing one.
• If the new investment is marginal to the
business
Opportunity cost of capital
• Opportunity cost of capital is the expected
rate of return offered in capital by equivalent
risk asset.
Effect of Inflation on Investment decisions
Real & Nominal Interest Rates
• Cost of borrowing the funds is the nominal
interest rate or money interest rate (i).
– It is also the funds supplier’s required rate of return.
• Interest rate adjusted for the effects of inflation
(Inf) is the real interest rate (r).
1+nominal interest rate
1  real interest rate =
1+inflation rate
r 
(1  i )
(1  Inf )
1
30
Example 1
Assume that inflation is expected to be 5% per annum
and the prevailing market interest rate is 10% per
annum. What is the real rate of interest?

(1  0.1)
(1  0.05)
 0.0476
1
or 4.76%
31
Real vs. Nominal Cash flows

Real Cash flow
• accounts for all cash flow for the future at its present value.
ie: assumes a zero inflationary position

Nominal Cash flow
• accounts for inflation, which affects the price of goods by
altering the value of currency.

Inflation Rule
•
•
•
•
Be consistent in how you handle inflation!!
Use nominal interest rates to discount nominal cash flows.
Use real interest rates to discount real cash flows.
You will get the same results, whether you use nominal or real
figures
http://www.fao.org/docrep/w4343e/w4343e07.htm#TopOfPage32
Inflation
• Typically discount rate is the money cost of
capital which includes the adjustment for
inflation.
• Cash flows are normally in real terms
• Fundamental is inflated cash flows should be
discounted by the money cost of capital.
• Real and money cost of capital is embodied by
Fishers formula.
(1+nominal)=(1+Real)x(1+Inflation)
Capital allowances
• This is the standard tax allowances given for
the depreciation of a fixed asset at standard
rates given by the inland revenue.
• It will save the substantial amount of tax and
should be adjusted as a saving of the current
tax liability.
Risk adjusted discount rate
• If the project is exposed to different risk
profile corporate cost of capital may not be
sufficient to discount the cash flow.
• Risk adjusted discount rate is the applicable
rate to discount the excess of risk.
• Cap m is the base to determine the risk
adjusted COC.
• Even past experience may help to determine
it.
Capital Rationing
• Selecting most viable projects when the funds are
become a limiting factor.
• Management's approach to allocating available
funds among competing investment proposals;
only the proposals that maximize the total net
present value (NPV) of the investment are selected.
• Therefore capital rationing is the method to
allocate limited funds for the most competing
projects in the company.
Limiting factor
• Limiting factor is the factor which limits the
organization operation.
• Limiting factor is also referred to as a
“Constrain”.
• It may be labour hours, material, machine
hours or organization funds
Hard capital rationing
• This is where funds are become limited due to
external limiting factors. Funds may be limited
in the money market due to poor economic
performance in the economy, thus funds are
limited in the banks or cost of borrowing is
relatively high.
• Lack of collaterals either fixed or floating
• Higher gearing level of the company is limited
the access to the borrowings.
Soft capital rationing
• This is where funds are limited inside the
organization.
• It is become a budget constrain.
• Business is running out of cash or not having
sufficient retained profits to funds the new
projects.
Capital rationing with single period
• This is where funds are limited in a single
period where company has to select most
viable investment opportunities among many.
• There are two basic projects.
• Divisible or indivisible projects
• Divisible projects are undertaken in a
percentage based on the availability of the
funds.
• Indivisible projects are not undertaken on a
partly basis and it undertakes the full project
Profitability Index(PI)
• Profitability Index is the main method of
undertaking projects when the funds are
limited.
• Profitability Index= NPV of the project
Investment
• PI indicates return per one Rupee investment
• Higher PI projects are adding value to the
business.
Example
• ABC Ltd has identified following projects for the implementation
in 2015. But organization capacity of accepting those projects
are limited by the funds constrain of USD 2,000,000.
Project
Investment
NPV
A
USD 800,000.00
650,000.00
B
USD 500,000.00
420,000.00
C
USD 400,000.00
150,000.00
D
USD 600,000.00
400,000.00
USD 2,300,000.00
1,620,000.00
Total
All the projects are divisible. What is the best project mix which can
maximize the value?
Mutually exclusive projects.
• A Project whose cash flows have no impact on
the acceptance or rejection of other projects
is termed as Independent Project. Thus, all
such Projects which meet this criterion should
be accepted.
•
Investment A
Discount
Rate
NPV
Investment B
Discount
Rate
NPV
0
10
0
10
11.16
%
$2,000
180
0
14.33
%
$6,000
1,414
0
Continue
• In mutually exclusive projects exist where the
acceptance of one project exclude the acceptance of
the other project.
• Therefore, such projects cannot be undertaken
simultaneously. Hence, while choosing among
Mutually Exclusive Projects, more than one project
may satisfy the Capital Budgeting criterion.
• However, only one project can be accepted. Which
project should be accepted depends on different
factors like initial investment, time period required for
completion, strategic importance of the project, etc.
usually the project which adds more value to the
business in the long run will be selected.
Example
Investment
Cash flow
Cash flow
Cash flow
Cash flow
Project X
700,000
343,000
343,000
343,000
Project Y
1,200,000
552,000
552,000
552,000
Company cost of capital is 10%. Which project should the company accept?
Net present value profile with
crossover
PPT 12-21
Net present value ($)
Dis.rate
B
7,000
0
Investment B
6000
2979
0
NPV A NPV B
A
Investment C
60
70
5 43.13
47.88
10 29.08
29.79
15 17.18
14.52
20
7.06
2.31
25
-1.63
-8.22
Investment C
IRRC = 22.49%
Investment B
10%
IRRB = 21%
Crossover point
Discount rate (percent)
B
25%
C
Net present value profile with
crossover
 Cross-Over Rate is the discount rate where NPV
profiles of two (or more) projects intersect,
meaning that they are equal.
 When this occurs ranking projects will have
different results depending on what discount rate
is used. A rate below the Cross-Over Rate will
produce one ranking, a rate above it will produce
another ranking.
Adjusting for risk
• Risk is The chance that an investment's
actual return will be different than expected. Risk
includes the possibility of losing some or all of the
original investment.
• Risk may change the expected outcome of the
project.
• A modeling and risk assessment procedure could
mitigate the risk of the planned outcome.
• There are different risk modeling techniques are
used to evaluate the risk of a long term
investment opportunity.
Risk assessment techniques in capital
budgeting
• Sensitivity analysis
• Risk adjusted cost of capital
• Decision tree
Are widely used …
Sensitivity analysis
• It evaluates the sensitivity of the variables in the cash
inflows and out flows to the planned NPV out come.
 Sensitivity of the sales volume
 Sensitivity of the cost
 Sensitivity of the cost of capital
• An analysis can be made of all the factors to ascertain
by how much each factor must change before the NPV
reaches zero, the indifference point.
Example
• The initial outlay of a equipment is
Rs.100,000.It is estimated that it will generate
10000 units per annum for next 4 years.
Contribution per unit 6.00 and the fixed cost
are expected to be Rs.26,000 PA. COC 5%.
1. Calculate the NPV
2. By how much can each factor change before
the company becomes indifferent to the
project?