Investment slideppt.pptx

Investment decisions
Yogesh Chauhan, IIM Raipur

Investment decisions
A firm’s shareholders prefer to be rich rather than poor. Therefore, they want to invest
in every project that is worth more than its costs (maximization of shareholder wealth
• CCD has an opportunity to open a shop at IIM Raipur. At the same time, it has
another opportunity at IIIT Raipur. Now, CCD comes to you to take your opinion.
My intuition tells me that if my return on invested capital is more than the cost of
fund (capital), I should invest in that project.

Properties of a good decision criterion
1. Make sense (benefits exceed costs)
2. Unit of measurement
3. Benchmark obvious
4. Easy to communicate
5. Easy to compare different ideas/projects.

Net present value
• First, the forecast the cashflows generated by the project over its economic life.
• Second, determine the appropriate opportunity cost of capital. This should reflect
both time value of money and the risk associated with the project.
• Third, use this opportunity cost of capital to discount future cashflows of the
project.
• Finally, calculate Net present value (NPV) by subtracting initial investments from
present value.
• Invest in the project if its NPV is greater than zero.

Net present value (NPV)
• Assume expected returns of investors (cost of capital) is 10%, what is the NPV of
the following idea?
Year Cashflow Present value
0 Rs -1000 Rs -1000
1 Rs. 800 Rs 727
2 Rs. 800 Rs. 661
NPV Rs 388
0
Rs -1000
1
Rs 800
2
Rs 800
Rs 727
Rs 661
Rs 1388

Net present value (NPV): Intuition
• We receive cashflows from the project.
• We use expected returns of investors to discount future cashflows. Therefore,
expected returns do not belong to the project, but it comes from investors (supplies
of capital). Investors demand more expected returns when you demand their
capital for riskier projects.

NPV: Essence
• Value is always incremental.
• We have invested Rs. 1000, I expect to receive after 2 two years, with 10%
expected returns
=1000*(1+10%)^2=Rs 1210 (Break-even)
The project delivers to me
0 1
Rs. 800
2
Rs. 800
+
Rs. 800*1.1=880
Rs. 800
Rs 1680
Incremental value=Rs. 1680-Rs 1210=Rs. 470
What is the present value of Rs. 470 at time 0=
470
1.1^2
= 𝑅𝑠 388 (𝑒𝑞𝑢𝑎𝑙 𝑡𝑜 𝑁𝑃𝑉)

NPV (Formula)
• The NPV is defined as:
• 𝑁𝑃𝑉 = −𝐼 +
𝐶𝐹1
(1+𝑅)
+
𝐶𝐹2
(1+𝑅)^2
+
𝐶𝐹3
(1+𝑅)^3
+ ⋯ … . +
𝐶𝐹𝑛
1+𝑅 𝑛
• Where I is the initial investment in the project and CF is the cashflows.

Properties of NPV
2. Unit of measurement: Rs
3. Benchmark obvious?
4. Easy to communicate:

Example : NPV
• We plan to invest in a project. Please advice where we should invest. Investors are expected
to accept 10% return.
Year Project A Project B
0 -Rs.1,000.00 -Rs.1,000.00
1 Rs.416.00 Rs.516.00
2 Rs.200.00 Rs.400.00
3 Rs.210.00 Rs.110.00
4 Rs.144.00 Rs.244.00
5 Rs.340.00 Rs.140.00

NPV
• Net present values are additive. The NPVs of individual project can be added to arrive at a
total NPV of a business.
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚
= 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡𝑠 𝑖𝑛 𝑝𝑙𝑎𝑛𝑐𝑒 + 𝑁𝑃𝑉 𝑜𝑓 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑓𝑢𝑡𝑢𝑟𝑒 𝑝𝑟𝑜𝑒𝑗𝑐𝑡𝑠
• Implicitly in all present value calculations are assumption about the rate at which cashflows
that occur during the project lifetime, that is, intermediate cashflows, get reinvested at hurdle
rate (expected rate of returns), which is cost of capital. In other words, intermediate
cashflows would be reinvested in other project (s) having similar risk (therefore similar cost
of capital)
• Since NPVs are additive, NPV rule is the decision rule most consistent with the objective of
maximizing firm value.

Internal rate of returns
• Internal rate of returns is annual (expected) return from the project.
• What is the Internal rate of returns (IRR) of his idea?
Year Cashflow
0 Rs. – 1000
1 Rs. 1100

IRR: Intuition
• What would be the NPV of the project if you use IRR as expected returns of
investors?
−1000 +
1100
(1.1)
=0
• IRR is a discount rate that makes the NPV zero. Intuitively, it is measure of the
return that you are earning on an investment, considering both how much the
cashflows on investments will be and when they will be received. Therefore, IRR
is also called annual (expected) returns from the project.

Example: IRR
Year Project A
0 -Rs.1,000.00
1 Rs.416.00
2 Rs.200.00
3 Rs.210.00
4 Rs.144.00
5 Rs.340.00
0= −1000 +
416
1+IRR
+
200
1+IRR ^2
+
210
1+IRR ^3
+
144
1+IRR ^4
+
340
(1+IRR)^5
IRR=10.45%
Is this a good project?

IRR: Graphic representation
-50
-25
0
25
50
75
100
125
150
175
200
225
250
275
300
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
NPV
Cost of capital
NPV

Properties of IRR
2. Unit of measurement:
3. Benchmark obvious?:

Problems associated with IRR
• Problem 1: There may be more than one IRR.
Year Project C
0 -100
1 230
2 -132

Intuition
-1.20
-1.00
-0.80
-0.60
-0.40
-0.20
0.00
0.20
0.40
5% 7% 9% 10% 11% 13% 15% 17% 19% 20% 21% 23% 25% 27% 29% 30% 31%
NPV
Discount rate
NPV

Problems associated with IRR
• The IRR is best suited for projects in which one or more cashflows are followed
by a series of cash inflows with no further net outflows. Typically, when the sign
of the annual cashflows (positive or negative) changes more than once during the
life of a project, there will be multiple IRR. This is because such project include
both lending (downward slope) and borrowing projects (upward slope).

Mutually
exclusive
projects
Project
Year M N
0 -1680 -1680
1 1400 140
2 700 840
3 140 1510
Cost of capital 9% 9%
IRR 23% 17%
NPV Rs.301.69 Rs.321.91

Fisher’s intersection
Cost of capital NPV
M N
7% 354.10 417.14
8% 327.57 368.48
9% 301.69 321.45
10% 276.42 275.97
11% 251.76 231.99
12% 227.68 189.43
13% 204.17 148.24
IRR 23% 17%

Problems associated with IRR, and NPV
• If the required rate of return is greater than the intersection rate, both NPV and IRR
methods will yield consistent results. On the other hand, if the required rate of return
is lower than the intersection rate, both NPV and IRR methods will provide
contradictory results. That is, the higher IRR project would have lower NPV.
• NPV assumes that all intermediate cashflows would be reinvested at cost of capital,
where IRR assumes that all intermediate cashflows would be reinvested at IRR.
However, both projects are affected by this assumption, it has a much greater effect
on Project A, which has higher cashflows earlier on.
• Which assumption is more dangerous?
• Given this problem, the project should be selected based on NPV, since it is
consistent with the value maximization proposition.

Incremental cashflows and IRR
Project
Year M N Incremental cashflow
0 -1680 -1680 0
1 1400 140 1260
2 700 840 -140
3 140 1510 -1370
Cost of capital 9% 9% 9%
IRR 23% 17% 10%
NPV 276.78 294.91 ($19.76)

NPV versus IRR
• IRR would bias you for long-term projects, the more serious are the consequences
of the reinvestment rate assumption made by the IRR rule. This is because the IRR
rule implicitly assumes that the firm has and will continue to have a fountain of
projects yielding returns like returns earned by the project under consideration.
• One solution that has been suggested for reinvestment rate assumption is to
assume that intermediate cashflows get reinvested at the hurdle rate (cost of
capital). This approach is call Modified internal rate of return (MIRR).

MIRR
Year Project A
Project B
0 -25,000 -17,000
1 6,000 16,000
2 8,000 16,000
3 9,000 16,000
4 7,000 16,000
5 13,000 -52,000
Project A’s future values of intermediate cash=6000*(1.1)^4 + 8000*(1.1)^3 + 9000*(1.1)^2 + 7000*(1.1)^1 + 13000*(1.1)^0=
Rs 51023
-25000=
51023
(1+𝑀𝐼𝑅𝑅)
= 15.33%
The firm can reinvest all cashflows at reinvestment rate
(Cost of capital).
The firm can decide the financing costs.

NPV versus
IRR
Year A B
0 -1000 -100000
1 1500 120000
2 500 75000
NPV 777 71074
IRR 78% 65%
Profit to
investment
ratio 71% 65%

NPV versus IRR
• If a business has limited access to capital, has a stream of surplus value projects
and faces more uncertainty in its project cash flows, it is much more likely to use
IRR as its decision rule.
• Small, high-growth companies and private businesses are much more likely to
use IRR.
• If a business has substantial funds on hand, access to capital, limited surplus value
projects, and more certainty on its project cash flows, it is much more likely to use
NPV as its decision rule.
• As firms go public and grow, they are much more likely to gain from using NPV

Payback period
• The length of time required for an investment to recover its initial investment in
terms of profits or savings. The typical payback rule states that a project should be
accepted if its payback period is less than or equal to some targeted length time.
Year Project A Project B
0 -500 -500
1 100.00 200
2 200.00 150
3 100.00 100
4 144.00 100
5 340.00 500

Discounted Payback period
Year
Project
A
Project B
Discounted cashflows
(Project A)
Discounted cashflows
(Project B)
0 -500 -500 -500 -500
1 100 200 91 182
2 200 150 165 124
3 100 100 75 75
4 144 100 98 68
5 340 500 211 310
Payback
period 4.58 years 4.8 years

Properties of payback period
2. Unit of measurement:
3. Benchmark obvious?:

Projects with unequal lives
• Machine A has a cost of Rs 500 with the life of 3 years, and it requires
maintenance expense of Rs 120 per annum.
• Machine B has a cost of Rs 600 with the life of 4 years, and it requires
maintenance expense of Rs 100 per annum.
• Which machine should we buy if cost of capital is 10%.

Projects with unequal lives
A B
0 500 600
1 120 100
2 120 100
3 120 100
4 100
Present value $798.42 $916.99
Normally, we select Machine A, since it has lower present value of cash outflow. However, Machine B has longer
Life compared to Machine A

Equivalent annual method
• Machine A: $798.42 =C ∗
(1+𝑟)3−1
(1+𝑟)3∗𝑟
= C ∗
(1+10%)3−1
(1+10%)3∗10%
• Machine B: $916.99 =(C ∗
1+𝑟 4−1
1+𝑟 4∗𝑟
) = C ∗
(1+10%)4−1
(1+10%)4∗10%
• Now the payment stream of Machine A is equivalent to annuity payments of Rs. 321.1 made at
the end of each year.
• Now the payment stream of Machine B is equivalent to annuity payments of Rs. 289.3 made at
the end of each year.
• Alternatively, we can say that we have financed the machine with given annual installment.
A B
Present value $798.42 $916.99
PVIFA(end) $2.49 $3.17
Equivalent annual cost 321.1 289.3

Estimation of cashflows

Hi Accountant, Can you buy an Ice-cream through Earnings?
• Financial accountant focus more profit (income), can we pay dividend to investors through
profit?. In order to pay dividend, the firm needs to generate cashflow.
• If you paid Rs 1 million in cash for a building as part of a new capital budgeting
project. The entire Rs 1 million is an immediate cash outflow. However, assuming
straight-line depreciation over 20 years, only Rs 50,000 (10,00,000/20) is considered as
accounting expenses in the current year. Current earnings is therefore reduced by Rs
50,000 (Less the depreciation tax shield). The remaining Rs 9,50,000 is expensed over
the following 19 years. For capital budgeting purposes, the relevant cash outflow at
Year 0 is the full Rs 10,00,000, not the reduction in earnings of only Rs 50,000
• If you have sold Rs 10,00,000 goods to the customer at credit of 1 year. If the COCG
is 80%, the accountant would record Rs 2,00,000 profit before tax, but actually cash
flow is negative (no Ice-cream, please ), since we must pay corporate tax on profit
(that is cash outflow).

Measures of return: earnings versus cash flows
• Principles Governing Accounting Earnings Measurement
• Accrual Accounting: Show revenues when products and services are sold or
provided, not when they are paid for. Show expenses associated with these
revenues rather than cash expenses.
• I do cash business and maintain zero inventory. What would be my
working capital?
• Operating versus Capital Expenditures: Only expenses associated with
creating revenues in the current period should be treated as operating
expenses. Expenses that create benefits over several periods are written off
over multiple periods (as depreciation or amortization).

Accounting earnings to cashflow
Free Cash flow to Firm (Project)
Sales (Price *unit expected to be sold)
- Cost of goods sold
- Deprecation (Non-cash expenses)
Operating profits
- Corporate tax @30%
After-tax Operating profits
+ Deprecation(Non-cash expenses)
-Capital Expenditures
-Increase in Working Capital
Cashflows from operations (projects)
Rs 5000
-Rs 2500
-Rs 500
Rs 2000
Rs -600
Rs 1400
+Rs 500
-Rs. 300
-Rs. 200
Rs 1400
We must subtract out cashflow which are not
expensed (Such as capital expenditure
Accruals profit to cash flow
We must add back non-cash expenses

The Working Capital Effect
• Intuitively, money invested in inventory or in accounts receivable cannot be used
elsewhere. It, thus, represents a drain on cash flows.
• To the degree that some of these investments can be financed using supplier credit
(accounts payable), the cash flow drain is reduced.
• Investments in working capital are thus cash outflows
• Any increase in working capital reduces cash flows in that year
• Any decrease in working capital increases cash flows in that year
• To provide closure, working capital investments need to be salvaged at the end of the
project life

Mega example
• ABC ltd has obtained a license to run a trading firm for 6 years. The product would be purchased
from manufacturing firm for Rs 10 per unit and sold to customers for Rs 20 per unit. The estimated
annual marketing cost would be Rs. 18,000.
• Other information associated with the new product is given below:
• Cost of equipment needed (investment at 0 time ): Rs 30,000, where deprecation would be
charged by Straight line method.
• Working capital needed: Rs 40,000. Every year, 1% of revenue additional working will be
required.
• Repairs and maintenance of equipment after 5 years (capital expenditure): Rs. 2,500
• Residual value of equipment after 6 years: Rs. 5,000
• The initial working capital would be released at the end of 6-year period.
• The expected annual sales for the next are 5,000 units of product and expected to grow by 5%
every year, and the unit price will be constant.
• Management plans to finance this project by 50% equity (cost of equity 20%), and 50% debt
(pre-tax cost of debt 15%).
• Tax rate=30%
Suggest whether we should invest or not?

Calculation of deprecation, and working capital
Cost of equipment 30000
Less residual value -5000
Net cost of equipment 25000
Life of the equipment (in years) 6
Deprecation per year 4167
0 1 2 3 4 5 6
Total revenues 100000 105000 110250 115763 121551 127628
Initial investment in working
capital 40000
Investment in working
capital 1000 1050 1103 1158 1216 1276
Working capital 41000 42050 43153 44310 45526 46802
Change in working capital 1000 1050 1103 1158 1216 1276
Recovery of working capital 46802

Year
0 1 2 3 4 5 6
Cost of equipment (30000)
Working capital investment (40000)
Unit 5000 5250 5513 5788 6078 6381
Selling price 20 20 20 20 20 20
Total revenues 100000 105000 110250 115763 121551 127628
Less purchased price (COGS) (50000) (52500) (55125) (57881) (60775) (63814)
Marketing costs (18000) (18000) (18000) (18000) (18000) (18000)
Depreciation (4167) (4167) (4167) (4167) (4167) (4167)
Operating profits 27833 30333 32958 35715 38609 41647
Corporate tax @ 30% (8350) (9100) (9888) (10714) (11583) (12494)
After-tax operating profits 19483 21233 23071 25000 27026 29153
Depreciation 4167 4167 4167 4167 4167 4167
Capital expenditure 0 0 0 0 (2500) 0
Change in Working Capital (1000) (1050) (1103) (1158) (1216) (1276)
Residual value of equipment 5000
Cashflows from the projects (70000) 22650 24350 26135 28009 27477 83845

Calculation of cost of capital
Debt portion 50%
Equity portion 50%
Cost of equity 20%
Cost of debt 15%
Tax-rate 30%
Cost of capital 15.25%
0.5 ∗ 20% + 15% ∗ 1 − 30% ∗ 0.5 = 15.25%

NPV, IRR, MIRR, and Payback period
• NPV: -70,000 +
22650
(1.1525)
+
24350
(1.1525)^2
+
26135
(1.1525)^3
+
28009
(1.1525)^4
+
27477
(1.1525)^5
+
83848
(1.1525)^6
= 𝑅𝑠. 50,226.25
• IRR: 0=-70,000 +
22650
(1+𝐼𝑅𝑅)
+
24350
(1+𝐼𝑅𝑅)^2
+
26135
(1+𝐼𝑅𝑅)^3
+
28009
(1+𝐼𝑅𝑅)^4
+
27477
(1+𝐼𝑅𝑅)^5
+
83848
(1+𝐼𝑅𝑅)^6
: IRR = 34.50%
• MIRR=24.32% (assuming that financing and reinvestment rate is equal to cost of
capital)
• Payback period: Close to 3 years
0 1 2 3 4 5 6
Cashflows (70000) 22650 24350 26135 28009 27477 83845
Cumulative cashflows (47350) (23000) 3135 31144 58621142467

Cashflows: Important principle
• Estimate all cashflows on an incremental basis
• Estimate all cashflows of a firm without projects.
• Estimate all cashflows of a firm with project.
• The incremental cashflows would be the difference between cashflows with
projects and cashflows without projects.
• Do not forget importance of year 0 and the last year of chosen timeline for the
project.
• At the time of 0, we need to invest in the project and working capital needs.
• Don’t mix investment with financing expenses.
• Don’t compare projects with unequal lives.

What is a sunk cost? Any expenditure that has already been incurred and cannot be
recovered (even if a project is rejected) is called a sunk cost.
• The firm has paid Rs 10,000 to a market research firm to do market analysis
for the product.
• The cost of preparation of MBA entrance examination while evaluating ROI
of Business school .
The sunk cost rule: When analyzing a project, sunk costs should not be considered
since they are not incremental.
Can we ignore sunk cost ? (behavior biases or fear biases)
I purchased two movie tickets to watch movie to be played 30 km from my home. On
the day of movie, there is thunderstorm. I (my wife ): ) decided to go. What if, I
would have got movie tickets free of costs?
Incremental cashflow: Sunk costs

Incremental cashflow: Allocation cost
• Firms allocate costs to individual projects from a centralized pool (such as general
and administrative expenses) based upon some characteristic of the project (sales
is a common choice, as is earnings. We should include the cost that is associated
with the project.
• For instance, You are paying salary to a manager to look after factory. Now,
the same manager will see Project A two days in a week. The monthly salary
of the manager is Rs 50,000. Would you include any cost of the manager in
Project A?

Incremental Cash Flows: Opportunity costs
• Opportunity costs do matter. An opportunity cost arises when a project uses a
resource that may already have been paid for by the firm
• The firm has an empty warehouse in Mumbai that can be used to store a new
line of electronic pinball machines. Should the warehouse be considered a
cost in the decision to evaluate the project?
• When a resource that is already owned by a firm is being considered for use in a
project, this resource must be priced on its next best alternative use, which may be
• A sale of the asset, in which case the opportunity cost is the expected proceeds
from the sale, net of any capital gains taxes
• Renting or leasing the asset out, in which case the opportunity cost is the
expected present value of the after-tax rental or lease revenues.
• Use elsewhere in the business, in which case the opportunity cost is the cost
of replacing it.

Case 1: Foregone Sale?
• Assume that Reliance owns land in Raipur already. This land is undeveloped and
was acquired several years ago for Rs 5 million for a Telecom that was never built.
It is anticipated, if this Reliance opens Reliance retail, then this land will be used
to build the store. The land currently can be sold for Rs 40 million, though that
would create a capital gain (which will be taxed at 20%). In assessing store at
Raipur, which of the following would you do:
• Ignore the cost of the land, since Reliance owns its already
• Use the book value of the land, which is Rs 5 million
• Use the market value of the land, which is Rs 40 million.
• Other:

Case 2: Incremental Cost? An Online Retailing Venture
for BB store
• The initial investment needed to start the service, including the installation of additional phone
lines and computer equipment, will be Rs. 1 million. These investments are expected to have a life
of four years, at which point they will have no salvage value. The investments will be depreciated
straight line over the four-year life.
• The revenues in the first year are expected to be Rs. 1.5 million, growing 20% in year two, and
10% for the next two year. The cost of the books will be 60% of the revenues in each of the four
years.
• The salaries and other benefits for the employees are estimated to be Rs.150,000 in year one and
grow 10% a year for the following three years.
• The working capital, which includes the inventory of books needed for the service and the
accounts receivable will be 10% of the revenues; the investments in working capital must be made
at the beginning of each year. At the end of year 4, the entire working capital is assumed to be
salvaged.
• The tax rate on income is expected to be 40%.

Estimation of cashflow
Year 0 1 2 3 4
Investment -1000000
Revenue 1500000 1800000 1980000 2178000
Operating expenses
Cost of books 900000 1080000 1188000 1306800
Salaries 150000 165000 181500 199650
Depreciation 250000 250000 250000 250000
Operating Income 200000 305000 360500 421550
Corporate Tax @40% 80000 122000 144200 168620
After-tax operating Income 120000 183000 216300 252930
Add depreciation 250000 250000 250000 250000
Working capital requirement -150000 -180000 -198000 -217800 0
Change in working capital -30000 -18000 -19800
Salvage value of Investment 0
Cashflow after taxes -1150000 340000 415000 446500 720730

NPV
• Cost of capital =18.12%
• NPV=Rs 64,719.44

The side costs…
• It is estimated that the additional business associated with online ordering and the
administration of the service itself will add to the workload for the current general
manager of the bookstore.
• As a consequence, the salary of the general manager will be increased from
Rs.100,000 to Rs.120,000 next year; it is expected to grow 5 percent a year
after that for the remaining three years of the online venture.
• After the online venture is ended in the fourth year, the manager’ s salary
will revert back to its old levels. ¨
• It is also estimated that BB store Online will utilize an office that is currently used
to store financial records. The records will be moved to a bank vault, which will
cost Rs. 1000 a year to rent.

Additional costs
Additional Costs 0 1 2 3 4
Increase in salary 20000 21000 22050 23152.5
Office Costs 1000 1000 1000 1000
Total additional costs 21000 22000 23050 24152.5
After-tax additional costs 0 12600 13200 13830 14491.5
Present value of Additional Costs
Rs. 30,446.89
NPV without Opportunity costs Rs. 64,719.44
NPV with Opportunity Costs Rs. 34,272.55

Opportunity costs aggregated into cash flows
Year 0 1 2 3 4
Investment 1000000
Revenue 1500000 1800000 1980000 2178000
Operating expenses
Cost of books 900000 1080000 1188000 1306800
Salaries 150000 165000 181500 199650
Depreciation 250000 250000 250000 250000
Increase in salary 0 20000 21000 22050 23152.5
Office Costs 0 1000 1000 1000 1000
Operating Income 179000 283000 337450 397397.5
Corporate Tax @40% 71600 113200 134980 158959
After-tax operating Income 107400 169800 202470 238438.5
Add depreciaiton 250000 250000 250000 250000
Working capital requirement 150000 180000 198000 217800 0
Change in working capital -30000 -18000 -19800
Salvage value of Investment 0
Cashflow after taxes -1150000 327400 401800 432670 706238.5
Cost of capital 18.12%

Investment slideppt.pptx

Recommended

Recommended

More Related Content

Similar to Investment slideppt.pptx

Similar to Investment slideppt.pptx (20)

More from Manisha Makhija

More from Manisha Makhija (7)

Recently uploaded

Recently uploaded (20)

Investment slideppt.pptx