INVESTMENT VALUATION
Prof. Antonio Salvi
Introduction
❑ A central topic in corporate finance is that the allocation of resources to investments.
❑ Investments determine the long-term prospects and performance of any company.
❑ Finance management must act as the glue for all information in structuring an
investment evaluation process that is sound and easily understood by management.
❑ "Finance serves other business functions and economic stakeholders, broadly
defined."
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Agenda
15 Introduction
15.1 Investments Classification and Decision Analysis Profiles
15.2 Investment Evaluation Criteria
15.3 Comparison of NPV and IRR
3
Definition and classification of investments (1/3)
❑ In a nutshell, an investment can be defined as an outflow of monetary resources that is
usually followed by positive flows that are themselves monetary. Or it can be seen as a
''deferred consumption over time.''
❑ It can involve both tangible and intangible assets.
❑ The economic-financial profile needs to be examined before a decision on resource
allocation is made. Then other factors underlying the decision (e.g. motivations, etc.) can
be considered.
• Explicit investment: Projects in which both
cash inflows and outflows are net. The first
flows are outflows and are determined in
Classification by the implementation phase, while the
type of flows inflows occur in the operating phase.
• Implicit investment: projects where there
is no net allocation of inflows and outflows
(e.g., university studies...).
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Definition and classification of investments (2/3)
• Interdependent investments: economic-financial results depend on other investment
decisions.
• Independent investments: the degree of interdependence between projects is zero.
Classification by • Mutually exclusive investments: the realization of one investment makes the other
degree of
investment impossible.
interdependence
• Competing investments: given scarce resources, 2 or more projects may compete with
each other.
• Sequential investments: one project is needed, at different times, to complete other
investments.
• Investments that only affect costs (ex. Equipment renewal).
Classification by • Investments that exclusively affect revenues (ex. New product launch).
effects produced • Investments that affect the level of NWC (ex. Inventory optimization).
• Investments that affect the mix of costs, revenues and NWC (ex. Production capacity
expansion).
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Definition and classification of investments (3/3)
• Safety and general utility projects are regulatory compliance investments aimed at
protecting the health and safety of people and the environment (e.g., asbestos
abatement).
Classification by
type of project • Quality improvement projects are investments to improve the perceived quality of
both end products and management processes (e.g., training costs).
• Projects to increase profitability are related to reducing costs or increasing the
production capacity of the plant.
• Other types of projects: should include all investments not mentioned above (e.g.
investments in marketing for product image).
• Companies often rank investments according to the level of risk to which
Classification by they are exposed. Given risk levels, minimum returns are assigned/required,
risk below which the investment project is not considered. Careful ex-ante
assessment and ranking of both risks and acceptance probabilities is required.
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Investment Decision Analysis Profiles
❑ The CFO must consider three main profiles when making investment decisions:
COST-BENEFIT PROFILE
1
It aims to understand the extent to which the project creates or destroys value from an economic point of view. The
analysis, carried out using concise indicators, makes it possible to assess the economic viability of the project. The
economic viability analysis is based on: 1) the incremental cash flows of the project; 2) the risk profile of the
investment.
2 FEASIBILITY AND FINANCIAL
SUSTAINABILITY PROFILE
It examines the dynamics and magnitude of the company's income and expenses with the commitments of the flows
that the investment project will bring in the following years. Lack of liquidity timing between the company and the
investment can lead to financial constraints called capital rationing.
ECONOMIC AND FINANCIAL
3 COMMUNICATION PROFILE
The analysis of financial disclosure is an extremely sensitive aspect for all listed companies, but also for some unlisted
companies that are in a situation of raising capital from third parties necessary for the implementation of the project. If
such disclosure is not well structured and understood, in 99% of cases the project risks not being realized.
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Agenda
15 Introduction
15.1 Investments Classification and Decision Analysis Profiles
15.2 Investment Evaluation Criteria
15.3 Comparison of NPV and IRR
8
Investment Evaluation Criteria: Key Characteristics
❑ The evaluation criteria are based on 3 pillars, which are:
• An investment is cost-effective if the sum of cash inflows exceeds cash outflows. The
Size of cash flows dimensional aspect of cash flows, especially monetary cash flows, plays an important
role.
• Practice calls for cash flow coverage between 5-10 years. The duration depends on
Time distribution of flows the type of investment, risk and predictability of cash flows.
With the same flows but different time
distribution, which is the best investment and
why?
• Shifting cash flows over time involves incurring a cost (passive financing -> cost of
Financial value of time capital) or receiving an income (active financing -> return on capital) (''financial value of
time''). 9
Investment Evaluation Criteria (1/5)
Payback period
❑ The Payback Period (PRI or Payback Period - PBP) is the number of periods required for
the positive investment flows to offset the expenses incurred.
2,6 anni
𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
PBP =
𝑷𝒆𝒓𝒊𝒐𝒅𝒊𝒄 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘𝒔
2-3 anni
• If PBP < cut-off YES to project
• If PBP > cut-off NO to project
Limits
• The PBP does not consider the value of cash flows as a whole,
emphasizing only the liquidity of the investment rather than its
The rationale behind the use of PBP is ability to create value.
that the longer the payback period, the • Cash flows are not discounted and therefore the financial value of
less the investment is exposed to the
time is not considered. This can be remedied by discounting the
risk of cash flow volatility and
cash flows and applying the PBP (Discounted Payback Period -
uncertainty. 10
DPBP).
Investment Evaluation Criteria (2/5)
Accounting Rate of Return
❑ The accounting rate of return (ARR) determines the average incremental profitability
generated over the periods considered (Rm), given the average amount of investment
(Im).
• Rm average incremental operating income
𝑹𝒎 𝑹𝒎
ARR = ARR = • Im average incremental investment in “fixed”
𝑰𝒎 𝟏
( 𝑭𝑪+𝑵𝑾𝑪) capital (which we will denote by ½ FC), plus
𝟐
incremental net working capital (NWC)
❑ It is considered ½ FC because investments in fixed assets are subject to depreciation,
which reduces their net book value. This is not the case for NWC, which is more stable
over time.
❑ ARR should be compared to the expected return on similar assets (same risk profile) or
to the cost of the financial resources used.
❑ Limits of ARR • Uses accounting items instead of cash flows
• Uses averages instead of point-in-time values for the period
• Does not take into account the financial value of time
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Investment Evaluation Criteria (3/5) - A
Net present value - NPV
❑ The Net Present Value (NPV) of an investment is the algebraic sum of all discounted cash
flows generated by the project.
NPV > 0 INVEST
𝑛 𝐹𝑡 𝑛 𝐹𝑡
NPV =σ𝑡=1 𝑡 − 𝐹0 NPV =σ𝑡=0 𝑡
1+𝑘 1+𝑘
NPV < 0 DON’T INVEST
❑ NPV represents the best estimate of the incremental wealth generated by the
project as if it were immediately available.
The project has the capacity to generate flows
of sufficient size to repay the initial
If NPV > 0 expenditure(s), repay the capital invested in the
operation, and still release residual resources
for further use.
The project does not have the capacity to
If NPV < 0 generate flows of sufficient size to repay the
initial outlay(s), repay the capital invested in the
operation, and still leave residual resources for
further use. 12
Investment Evaluation Criteria (3/5) - B
Net Present Value - NPV
❑ An example of NPV discounted at a
cost of capital (k) of 10% is shown in
the table.
❑ Implicit in the NPV formula is the assumption that the cash flows generated by the
investment will be reinvested at the cost of capital k.
𝑛 𝐹𝑡
NPV =σ𝑡=1 𝑡 − 𝐹0
1+𝑘
❑ The NPV formula enjoys the property of linearity of cash flows. This allows the NPV
difference between Project A and Project B to be viewed as the difference between the
NPVs of the two projects.
• If NPV (A-B) > 0 project A will be chosen
NPV (A-B) = NPV (A) – NPV (B) • If NPV (A-B) < 0 project B will be chosen
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Investment Evaluation Criteria (4/5)
Internal Rate of Return (IRR)
❑ Internal Rate of Return (IRR), or Implicit Rate of Return (IRR), is the discount rate that
makes the net present value of a project zero.
If IRR > WACC then NPV > 0
𝑛 𝐹𝑡
NPV =σ𝑡=1 𝑡 − 𝐹0 = 0
1+𝐼𝑅𝑅 If IRR < WACC then NPV < 0
K* is the maximum acceptable
❑ IRR expresses the total return on financing. capital cost of the investment
❑ IRR takes into account the financial value of time: to have an NPV > 0.
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Investment Evaluation Criteria (5/5)
Discounted Profitability Index
❑ The Discounted Profitability Index (DPI) is the ratio of the present value of the positive
flows generated by the investment to the initial flow F0.
DPI > 1 YES to the project
𝑛
σ𝑡=1 𝐹𝑡 −𝑡
× 1+𝑘
DPI =
𝐹0 DPI < 1 NO to the project
❑ From an economic point of view, it shows how many (monetary) units can be freed up
for each unit invested (measuring the efficiency of the allocation of monetary
resources).
❑ It is an excellent criterion for skimming projects when financial resources are scarce and
projects compete with each other.
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Agenda
15 Introduction
15.1 Investments Classification and Decision Analysis Profiles
15.2 Investment Evaluation Criteria
15.3 Comparison of NPV and IRR
16
Comparison of NPV and IRR (1/4)
❑ Intermediate flow reinvestment rates and modified IRR
NPV • The flows are reinvested at • The flows are reinvested at IRR
the cost of capital k IRR
❑ Limits of IRR:
• The value of IRR is not a point measure of project profitability, but rather represents the return on a
combination of investments (the original initiative + additional initiatives that can be realized in the future by
reusing the incremental flows generated by the first at IRR).
• IRR cannot be used to compare the profitability of two or more investments.
❑ Modified IRR formula (MIRR):
σ𝑛𝑡=1 𝐹𝑡 × 1 + 𝑘 𝑛−𝑡
×(1+MIRR)-n-F0 = 0
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Comparison of NPV and IRR (2/4)
❑ Multiple IRRs or absence of IRR
The first member of the IRR
formula equation is a
polynomial of degree n. This
implies that whenever cash
flows change sign, it results in
MULTIPLE multiple IRRs. In these cases, Without
IRR the IRR criterion loses IRR
significance in its application.
Financing projects mirror investment projects in that they are
initially characterized by positive cash inflows, followed by negative
cash outflows in subsequent periods. The logic for accepting or
rejecting financing is as follows:
• IRR > k, then invest
FINANCING • IRR < K, then don’t invest
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Comparison of NPV and IRR (3/4)
❑ In practice, a constant discount rate is usually used throughout the discounting process.
❑ Importantly, discount rates are a function of interest rates and the uncertainty
associated with cash flows. These values can also vary significantly over time (variable
discount rates).
IRR must be compared to a
Allows to estimate different single rate of return
rates for each period
NPV IRR
Cannot use variable
Can use variable discount discount rates
rates
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Comparison of NPV and IRR (4/4)
❑ IRR application issues for alternative investments (choice between 2 or more alternative
projects).
The problem of project size is solved by:
Incremental IRR > k Invest in large project
Project size • Incremental Project Calculation (Large
Project - Small Project)
problem • Incremental IRR calculation Incremental IRR < k Invest in small project
The project timing problem is solved
by:
Timing • Incremental Project Calculation
problem (Project B - Project A)
• Incremental IRR calculation
Incremental IRR < K Incremental IRR > K
Invest in Project A Invest in Project B 20
