THE INVESTMENT DECISION MAKING PROCESS

P2 Chapter 5

Time Value of
Money -
Compounding
and dicounting
of amounts

Capital
Expenditure
(Over a period
longer than
12m)
Capital
Rationing - Not
Flexibility - Use
every project
of real options
can be
theory
undertaken at
the same time

The Capital Investment Process

Stage Interrelation Stage name Description Phase
no.
1 Identify objectives  Identify objectives of
organisation.
 There may be multiple
objectives.
 The capital investment
process seeks to achieve
maximisation of wealth by
maximising the net present
value of future net cash
inflows.
Creation phase
2 Search for Search for appropriate investment
investment opportunities
opportunities
3 Identify states of Identify the possible states of the
nature environment in the future that
will affect the outcome of the
investment. Revise objectives or
search for new opportunities
accordingly, if environment is
unfavourable.
4 List possible Discussed in detail later.
outcomes Examination questions typically
5 Measure payoffs involve listing the various
6 Select investment alternatives open to a firm,
projects identifying cash flows that are
relevant to each opportunity,
evaluating the value of these cash
flows and recommending an
optimum investment strategy.
7 Obtain There should be a capital
Decision phase
authorisation and expenditure committee to
implement project approve the plans and suggest
changes if any. There should be
systems and processes in place to
discuss capital investment
proposals in a way that
encourages managers to submit
realistic, achievable proposals.
8 Review capital It is like a post completion audit
investment or an appraisal of the investment Implementation
decision decision and is usually initiated 12 phase
months into the project.

Functions:
Capital Expenditure

1. co-ordinate capital expenditure policy

2. appraise and authorise capital expenditure on specific projects
3. review actual expenditure on capital projects against the budget
Committee

Multidisciplinary team composition:

1. Project engineer
2. Production engineer
3. Management accountant
4. Revelant specialist

Assumptions:
1. All cashflows are known with certainty
2. Sufficient funds are available to take all profitable projects
3. Zero inflation, ero taxation
 Time Value of Money
(Value of money changes with time)

Reasons:

Risk Consumption preference

Inflation (Earlier we receive the (More preference for
cash, more certain we immediate rather than
can be about it) delayed consumption)

Technique COMPOUNDING DISCOUNTING

Meaning Calculating the future/terminal Calculating present value of an
value of a sum invested today for a amount to be received in the
given number of years at a given future.
rate.
Formula FV = X(1 + r)n 1
𝑃𝑉 = 𝑋 ( )
(1 + 𝑟)𝑛
 FV – future value Or
 X – Initial investment PV = future value*discounting
 R – rate factor
 N – Time period Discounting factor = (1+r)(–n)
 PV – present value
 X – future value
 R – rate
 N – time period
Illustration $100 is invested in an account for $5,000 is required in 10 years. $x is
five years. The interest rate is 10% invested in an account earning 5%
per annum. interest p.a.
The value of the account after five The value of $x may be established
years can be calculated as follows: as follows:
FV = 100 (1.10)5 We know that FV = X (1+r)n
= $161.05 So we can insert these values into
the formula as follows:
$5,000 = X (1 + 0.05)10
X = $5,000/(1.05)10
X = $3070

R – Cost of finance tied up in the investment

Also known as:
1. Discount rate
2. Required rate of return
3. Cost of capital
 Investment
appraisal
methods

NPV IRR Payback period ARR

NPV – Net Present Value

 The net benefit/ loss in present value terms from an investment opportunity.
 Difference between the present value of investment (cash outflow) and present value of projected
cash inflows.
 Represents surplus funds earned on a project, thus showing the impact on shareholder wealth.

1. IF THE NPV OF A PROJECT IS POSITIVE, THAT MEANS THERE IS A NET

ADDITION TO SHAREHOLDER WEALTH (SINCE CASH INFLOW IS MORE
THAN OUTFLOW) – HENCE, GO AHEAD WITH THE PROJECT.

2. IF THERE ARE MULTIPLE PROJECTS WITH POSITIVE NPV, GO WITH THE

ONE WITH THE HIGHEST NPV.

3. IF THE NPV IS ZERO, IT STILL MEANS THAT THE INVESTMENT WAS FULLY
RECOVERED AND HENCE THE PROJECT SHOULD BE ACCEPTED.

In simple words, NPV is whatever goes into the shareholder’s pockets.

 If the NPV is 0, that means shareholders earned nothing.

 If the NPV is positive, it means they earned that much amount more than their investment.
 If the NPV is negative, it means they lost that much amount on that project.

ASSUMPTIONS:
1. All cash flows occur at the beginning of the year.
2. The investment happens in advance (at T0) and the cash inflows begin later (from T1)
ILLUSTRATION:
Creative ltd is considering 2 mutually exclusive projects with the following details:

Project name A B

Initial investment $450000 $100000

Scrap value at the end of 5 yrs $20000 $10000

Annual cash flows ($000) 1 200 1 50

2 150 2 40

3 100 3 30

4 100 4 20

5 100 5 20

Assume that the initial investment is at the start of the project and the annual cash flows is at the end of
each year.
Calculate the NPV for both the projects if the relevant cost of capital is 10%
SOLUTION:

Project A Project B
Year Discounting Cash flow PV (discounting Cash flow PV (discounting
factor ($000) factor*cash flow) ($000) factor*cash flow)
($000) ($000)
0 1 (450) (450) (100) (100)
1 .909 200 181.8 50 45.45
2 .826 150 123.9 40 33.04
3 .751 100 75.1 30 22.53
4 .683 100 68.3 20 13.66
5 .621 120 (100+20) 74.52 30 (20+10) 18.63
NPV 73.62 NPV 33.31
(sum of all PVs) (sum of all PVs)

Creative ltd should choose project A because its NPV is higher.

NPV as an investment appraisal technique

Advantages Disadvantages
Considers TVM Fairly complex
Measure of absolute profitability Not well-understood by non-finance managers
Considers cash flows Determining cost of capital maybe difficult
Considers whole life of project
NPV maximisation means shareholder wealth
maximisation
IRR – Internal Rate of Return
 Rate of return at which NPV is zero
 Basically depicts the rate which the project will return if it breaks even.

1. IF IRR> COST OF CAPITAL – ACCEPT PROJECT

2. IF IRR< COST OF CAPITAL – REJECT PROJECT

Methods of estimating IRR

(The exact IRR can only be calculated using excel)

Interpolation Graph

Steps:
Formula:
𝑁𝐿
1. Find out the NPVs at 2
IRR = L + * (H-L) costs of capitals such that
(𝑁𝐿−𝑁𝐻)
one NPV is negative and
one positive
2. Join the 2 NPVs and
L = lower rate of return wherever the line cuts
H = higher rate of return the X axis is the IRR
NL = NPV at lower rate of interest
NH = NPV at higher rate of interest

Accuracy:
This method only gives an estimate of the IRR. To make your answer
more accurate, follow the following rules:
1. Dont use rates which are too apart - 5% difference is sufficient
2. We should use one positive and one negative NPV to stay close to
the real answer
ILLUSTRATION:
If the following information is given, calculate the IRR

 At 10%, NPV was $33310

 At 20%, NPV was $8510
 At 30%, NPV was ($9150)
Solution:
We have to choose the two rates which are closest to each other and give one negative and one positive
NPV
Hence we choose 20% and 30%
Putting the values in the formula, we get:
8510
20% + ((8510+9150)) * (30%-20%) = 24.82%

Calculating IRR in different situations

Project with even cash flows Project with perpetuity

Steps:
1. Find cumulative discount factor - initial investment / Formula =
Annual inflow 𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑓𝑙𝑜𝑤
2. Find life of project, n * 100
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
3. Look along n year row of annuity table until closest value
of cum. discountfactor is found
4. The column with this figure is IRR

Illustration: Find IRR of investment

that costs $20000 and generates
Illustration: Find IRR of project with initial $1600 forever
investment $1.5million and 3 years of Solution:
$700000 inflow 1600
Solution: IRR = *100 = 8%
20000
1. Cum. discount factor = 1500000/700000 =
2.143
2. n = 3
3. the figure 2.140 appears in row of 3 years
and under 19% column
4. IRR = 19%
 IRR as an investment appraisal technique
Advantages Disadvantages
Considers TVM Not a measure of absolute profitability
Easily understood by non-finance managers Interpolation only gives an estimate of IRR
Considers cash flows Complicated calculation
Considers whole life of project Result may be in conflict with NPV result. In such a
case, decision should be taken on the basis of NPV.
Can be calculated without using cost of capital
(Though decision making requires cost of capital)
IRR maximisation means shareholder wealth
maximisation

 The IRR is not an actual cost of capital. It instead tells us the cost of capital at which the project will
break even. This cost of capital might never arise.
 The IRR is a useful piece of information when we are examining one project. It allows us to
determine the highest acceptable cost of capital. But when comparing one project to another, the
NPV figure is based on a more appropriate cost of capital. Therefore the NPV of projects should be
used when deciding which project in which to invest.

ATTITUDE TO RISK:
1. For a conservative investor, a low risk project with a lower NPV is better than a
high risk project with higher NPV.
2. A large project with a high NPV will normally be preferred to a small project with a
lower NPV but a higher IRR. A tiny project can have a very high IRR.

MIRR – Modified Internal Rate of Return

 MIRR is like IRR, but is unique, gives a measure of the return of a project and is a simple percentage.
 MIRR = Project’s return
 If Project return > company’s cost of finance  Accept project
 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 is insightful, but NPV is still a better measure for decision making.

Calculation of MIRR

Formula
MIRR = [(terminal value of inflows/ Present value of outflows) 1/n ] - 1
NPV and IRR in different scenarios
Annuities and perpetuities

 When a project has equal annual cash flows the annuity factor may be used to calculate the NPV
(and hence the IRR).
 The annuity factor (AF) is the name given to the sum of the individual DF.
 The PV of an annuity can therefore be quickly found using the formula: PV = Annual cash flow × AF
 As when calculating a discount factor, the annuity factors (AF) can be found using:
1−(1+𝑟)−𝑛
1. Annuity formula 
𝑟
2. Annuity tables (cumulative present value tables).
 PV of perpetuity = Cash flow/ r

Advanced annuities and perpetuities

 All annuity and perpetuity formulae assume the cash inflows begin at T 1. However, if the inflows
begin from T0, there are 2 ways to calculate the answer:
1. Calculate the PV by ignoring the payment at T0 when considering the number of cash flows and
then adding one to the annuity or perpetuity factor.
2. Add 1 to the annuity/perpetuity factor and apply the formula normally.

Delayed annuities and perpetuities

 If the cash inflows start later than T1, you calculate their PV at whatever point of time they are
starting and then discounting it back to T0.

Changing interest rates

 Throughout our discussion, it was assumed that the discount rate remains constant throughout the
project life, but in reality this doesn’t happen.
 If the discount rate changes every year, every amount needs to be discounted separately with their
exclusive discounting factor (using the relevant discounting rate for that 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 case, we need to pro-rate the discount
rate to match the period of the cash flows
 For instance, if the relevant period is 6 months instead of 1 year, then n will be ½ instead of 1.

Capital rationing – Dividing limited funds into unlimited project opportunities.

Capital rationing

Hard rationing: Soft rationing:

Rationing because of external Rationing because of internal
factors controls and decisions
Assumptions:
1. Individual projects are divisible. The resulting NPV will be pro-rated. For example, if only 25% of the
capital is available for a project only 25% of its NPV will be earned
2. Annual cash flows cannot be delayed or preponed.
3. Capital funds are just restricted in year 0.
Thus, projects need to be ranked as per their profitability and the highest ranking projects
need to be chosen, as per the availability of funds. Ranking happens using profitability index
𝑁𝑃𝑉 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
Profitability index =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠
Illustration:
Available funds = $10,000

Project Name A B C D
Profitability index 1.91 1.23 1.87 0.54
Investment 6700 2000 3300 1000
required
Here, we only choose project A and C since they have the highest PI and their initial investments add up to
$10,000, which is the total available fund.

Discounted Payback Profitability Index (DPBI)

𝑃𝑉 𝑜𝑓 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
DPBI =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑎𝑦
 This is a measure of the number of times a project recovers the initial funds invested.
 The higher the figure, the greater the returns.
 A DPBI of less than 1 indicates a negative NPV, i.e. that the present value of the net cash inflows is
less than the initial cash outlay.

Real options in capital investments

To add flexilibility to capital investments

(inspired by the concept of financial options)

Option to abandon
Option to expand/
Option to switch/ Ability to abandon the
Call to delay/defer contract
redeploy project midway if
the option to delay Ability to change the
Use the assets in conditions change or
the project without scale of operations as
other projects if the future forecasts are
losing the opportunity per results and market
conditions change negative (consider
conditions
only relevant costs)
Post completion audit
 Aids organisational learning.
 Learnings from current and past projects are fed into future decision making processes.
 It is forward looking approach, whereby the progress of projects are compared with the initial
expectations and required changes are made.
 This task is carried out by capital expenditure committee or appointed subcommittee.

Benefits Problems
Assumptions and plans kept accurate and realistic
May not be possible to identify costs and benefits
if managers know in advanced that there would be
of every project separately
an audit
Improves efficiency Time consuming and costly
Disciple and equality of forecasting techniques Post completion audits can make managers risk
improved averse
Motivation to managers due to post completion Strategic effects of projects may take years to
appraisal materialise
Reveals reliability and quality of suppliers and Uncontrollable factors cannot be managed even in
contractors future
Provides learning experience