finance

1. 6- 1
Topics Covered
A Review of The Basics
– NPV and its Competitors
The Payback Period
– The Book Rate of Return
Internal Rate of Return
Profitability Index
Linear Programming
Capital Rationing

2. 6- 2
NPV and Cash Transfers
Every possible method for evaluating projects
impacts the flow of cash about the company
as follows.
Cash
Investment
opportunity (real
asset)
Firm Shareholder
Investment
opportunities
(financial assets)
Invest Alternative:
pay dividend
to shareholders
Shareholders invest
for themselves

3. 6- 3
Strategic Business Plan
Every firm will have a Strategic Business
Plan…it is a long-term plan that provide
general guideline to operating executives:
– - to seek new products
– - set expansion plans for existing products
– - look ways to reduce production & distribution
costs
For each year, firms will have Capital Budget
which lists all the planned investments for the
coming year

4. 6- 4
Project Classification
 Capital budget involves cost and benefits analysis.
Different projects warrants different level of analysis,
some more complex than others. For this purpose, the
projects are categorized differently.
 Replacement: needed to continue current operations
 Replacement: cost reduction
 Expansion of existing products or markets
 Expansion into new products and markets
 Safety and/or environmental projects
 Others: catch all like office buildings, parking lots,
executive jets & intangible assets like computer software
and systems

5. 6- 5
Book Rate of Return
Book Rate of Return - Average income divided by average
book value over project life. Also called accounting rate
of return.
Managers rarely use this measurement to make decisions.
The components reflect tax and accounting figures, not
market values or cash flows.
assets
book
income
book
return
of
rate
Book 

6. 6- 6
NPV
NPV
 It recognizes ‘time value of money’
It depends on forecasted cash flows (and not
on book returns) from the project and an
opportunity Cost of Capital.
Since PV are measured in today $ terms,
you can add them (NPV) up….what are the
implications?

7. 6- 7
NPV
When applying NPV rule, make sure:
– - Only cash flows are relevant
– - Estimate cash flows on Incremental basis
– Incremental and not average
– Incidental effects
– NWC requirements
– Opportunity costs
– Forget sunk costs
– Overhead costs
– Salvage value
– - Treat inflation consistently

8. 6- 8
Payback
 The payback period is the number of years required to recover a
project’s costs from operating cash flows or how long will it takes
before the cumulative forecasted cash flow equals the initial outlay.
 The payback rule says only accept projects that “payback” in the
desired time frame.
 The shorter the payback, the better…greater project’s liquidity which
is important for small firms that lack access to capital markets.
 This method is flawed, primarily because it ignores later year cash
flows and the present value of future cash flows.
 This method gives equal weight to all cash flows before the cutoff
date.(Could use discounted cash flows to estimate payback period).
 Unlike NPV & IRR, payback period merely tells us when we get out
investment back.

9. 6- 9
Payback Period
 Despite its shortcomings, why is Payback period still popular among
senior managers?
 - To communicate the Idea of ‘profitability’…so that everyone in the
other departments that are involved can understand
 - Managers of large corporations may opt for short payback period
projects because quicker profits means quicker promotion.
 -Family firms with limited access to capital my lead them to choose
short payback projects even though longer payback projects have
higher NPV
 Since cash flows in the distant future are generally riskier than the
near-term cash flows, payback can be a risk indicator.

10. 6- 10
Payback
Example
Examine the three projects and note the mistake
we would make if we insisted on only taking
projects with a payback period of 2 years or less.
50
2
0
500
1800
2000
-
C
58
-
2
0
1800
500
2000
-
B
2,624
3
5000
500
500
2000
-
A
10%
@
NPV
Period
Payback
C
C
C
C
Project 3
2
1
0



11. 6- 11
Internal Rate of Return
It is the projects expected rate of return, and if it exceeds the costs of funds used to
finance the project, then the excess goes to increasing firm value. Conversely,
if the IRR is less than the cost of funds, the shareholders’ will have to make up
for the shortfall, which will cause firm value to decline. It is the breakeven
point.
Example
You can purchase a turbo powered machine tool gadget for $4,000. The
investment will generate $2,000 and $4,000 in cash flows for two years,
respectively. What is the IRR on this investment?
0
)
1
(
000
,
4
)
1
(
000
,
2
000
,
4 2
1







IRR
IRR
NPV
%
08
.
28

IRR

12. 6- 12
Internal Rate of Return
-2000
-1500
-1000
-500
0
500
1000
1500
2000
2500
1
0
2
0
3
0
4
0
5
0
6
0
7
0
8
0
9
0
1
0
0
Discount rate (%)
NPV
(,000s)
IRR=28%

13. 6- 13
IRR & Discount rate
 What is the difference between IRR and Discount
Rate that appear in the NPV formula?
– IRR is a profitability measure that depends
solely on the amount and timing of the project
cash flows.
– The opportunity cost of capital is a standard of
profitability that we use to calculate the
worthiness of a project. It is the expected rate of
return offered by other assets with similar risks
as the project being evaluated.

14. 6- 14
MIRR
Modified IRR is applied to overcome the
issue of multiple IRRs and reinvestment at
IRR.
PV costs = PV of terminal value

15. 6- 15
Internal Rate of Return
Pitfall 1 - Lending or Borrowing?
 With some cash flows the NPV of the project increases as the
discount rate increases.
 This is contrary to the normal relationship between NPV and
discount rates.
364
%
50
500
,
1
000
,
1
364
%
50
500
,
1
000
,
1
%
10
@
Project 1
0








B
A
NPV
IRR
C
C

16. 6- 16
Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
 Certain cash flows can generate NPV=0 at two different discount rates.
 The following cash flow generates NPV=$A 3.3 million at both IRR% of
(-44%) and +11.6%.
600
NPV
300
0
-30
-600
Discount
Rate
IRR=11.6%
IRR=-44%

17. 6- 17
Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
 It is possible to have a zero IRR and a positive NPV
339
500
,
2
000
,
3
000
,
1
%
10
@
Project 2
1
0



 None
C
NPV
IRR
C
C
C

18. 6- 18
Internal Rate of Return
Pitfall 3 - Mutually Exclusive Projects
 IRR sometimes ignores the magnitude of the project.
 The following two projects illustrate that problem.
 IRR is unreliable in ranking projects of different scale (use
incremental cash flow analysis)
818
,
11
%
75
000
,
30
000
,
20
182
,
8
%
100
000
,
20
000
,
10
%
10
@
Project 1
0







E
D
NPV
IRR
C
C

19. 6- 19
Internal Rate of Return
Pitfall 4 - Term Structure Assumption
 We assume that discount rates are stable during
the term of the project.
 If IRR is > COC, then accept, but what happens
when there are more than one IRRs?
 Using the same discount rate for ALL cash flows
implies NO DIFFERENCE between short and
Long-term discount rates!
 This assumption implies that all funds are
reinvested at the IRR.
 This is a false assumption.

20. 6- 20
Profitability Index
 When resources are limited, the profitability index
(PI) provides a tool for selecting among various
project combinations and alternatives
 A set of limited resources and projects can yield
various combinations.
 The highest weighted average PI can indicate
which projects to select.

21. 6- 21
Profitability Index
Example
We only have $300,000 to invest. Which do we select?
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
Investment
NPV
Index
ity
Profitabil 

22. 6- 22
Profitability Index
Example - continued
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
Select projects with highest Weighted Avg PI
WAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25)
(300) (300) (300)
= 1.01

23. 6- 23
Profitability Index
Example - continued
Proj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13
C 194,250 175,000 1.11
D 162,000 150,000 1.08
Select projects with highest Weighted Avg PI
WAPI (BD) = 1.01
WAPI (A) = 0.77
WAPI (BC) = 1.12

24. 6- 24
Linear Programming
 Maximize Cash flows or NPV
 Minimize costs
Example
Max NPV = 21Xn + 16 Xb + 12 Xc + 13 Xd
subject to
10Xa + 5Xb + 5Xc + 0Xd <= 10
-30Xa - 5Xb - 5Xc + 40Xd <= 12

25. 6- 25
Issues in applying LP
Why Linear Programming is not popular
despite its great potential in solving capital
budgeting problems?
– The models can be complex
– General problem of getting good data
– Models are based on the assumption that future
investment opportunities are known, whereas in
reality it is an on-going process

26. 6- 26
.
Soft Rationing…These are provisional
limits by management to help them in their
financial planning and control.
This could be due to ..over ambitious
divisional managers
Rapid corporate growth that has imposed
constraints on management, and soft
rationing is imposed when such constraints
cannot be quantified

27. 6- 27
Capital Rationing
Even if capital is not rationed, there could
be constraints in the form of limited
management time, lack of skilled labor,
capital equipment can impose constraint on
firm’s growth.
Hard rationing…this implies market
imperfections, when constraints are
imposed by markets.

28. 6- 28
Post Audit
 The post audit process in capital budgeting involves:
– -comparing actual results with the predicted project
results
– -explain the differences
Two main objectives of post audit:
- Improve forecasts
-Improve operations
“Academics worry about making good decisions, but
businesses worry about making decisions good”