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Project Investment Decision-Making

1. Net Present Value

2. Other Investment Criteria
3. Mutually Exclusive Projects
4. Capital Rationing
5. Discounted Cash Flows, Not Profits
6. Incremental Cash Flows
7. Treatment of Inflation

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Project Investment Decision-Making

8. Separate Investment & Financing Decisions

9. How Firms Organize the Investment Process
10. Some “What If” Questions
4.10.1 Sensitivity Analysis
4.10.2 Scenario Analysis
11. Real Options and the Value of Flexibility

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Net Present Value

Net Present Value - Present value of cash flows minus

initial investments.

Opportunity Cost of Capital - Expected rate of

return given up by investing in a project

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Net Present Value

Example
Q: Suppose we can invest $50 today & receive $60
later today. What is our increase in value?

A: Profit = - $50 + $60

= $10 $10
Added Value
$50 Initial Investment

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Net Present Value

Example
Suppose we can invest $50 today and receive $60
in one year. What is our increase in value given a
10% expected return?

60
Profit = -50 +  $4.55
1.10
$4.55 Added Value
$50 Initial Investment
This is the definition of NPV

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Net Present Value

NPV = PV - required investment

Ct
NPV  C0 
(1  r ) t

C1 C2 Ct
NPV  C0   ...
(1  r ) 1
(1  r ) 2
(1  r ) t

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Net Present Value

Terminology
C = Cash Flow
t = time period of the investment
r = “opportunity cost of capital”

The Cash Flow could be positive or negative at

any time period.

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Net Present Value

Net Present Value Rule

Managers increase shareholders’ wealth by
accepting all projects that are worth more
than they cost.

Therefore, they should accept all projects

with a positive net present value.

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Net Present Value

Example
You have the opportunity to
purchase an office building. You
have a tenant lined up that will
generate $16,000 per year in cash
flows for three years. At the end
of three years you anticipate
selling the building for $450,000.
How much would you be willing
to pay for the building?

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Net Present Value

$466,000
Example – continued(7% WACC) $450,000

$16,000 $16,000 $16,000

Present Value 0 1 2 3

14,953
13,975
380,395
$409,323

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Net Present Value

Example - continued
If the building is being
offered for sale at a price
of $350,000, would you
buy the building and what
is the added value
generated by your
purchase and management
of the building?

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Net Present Value

Example - continued
If the building is being offered for sale at a price of
$350,000, would you buy the building and what is the
added value generated by your purchase and management
of the building?

16,000 16,000 466,000

NPV  350,000  1
 2
 3
(1.07 ) (1.07 ) (1.07 )
NPV  $59,323

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Payback Method

Payback Period - Time until cash flows recover the

initial investment of the project.

The payback rule specifies that a project be

accepted if its payback period is less than the
specified cutoff period. The following example
will demonstrate the absurdity of this statement;
however time to “+” cash flow is a critically
useful measure.

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Payback Method
Example
The three project below are available. The company accepts
all projects with a 2 year or less payback period. Show how
this decision will impact our decision.

Cash Flows
Project C0 C1 C2 C3 Payback NPV@10%
A -2000 +1000 +1000 +10000 2 + 7,249
B -2000 +1000 +1000 0 2 - 264
C -2000 0 +2000 0 2 - 347

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Other Investment Criteria

Internal Rate of Return (IRR) - Discount rate at

which NPV = 0.

Rate of Return Rule - Invest in any project offering

a rate of return that is higher than the opportunity
cost of capital.

C1 - investment
Rate of Return =
investment

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Internal Rate of Return

Example
You can purchase a building for $350,000. The
investment will generate $16,000 in cash flows
(i.e. rent) during the first three years. At the end
of three years you will sell the building for
$450,000. What is the IRR on this investment?

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Internal Rate of Return

Example
You can purchase a building for $350,000. The investment will
generate $16,000 in cash flows (i.e. rent) during the first three years.
At the end of three years you will sell the building for $450,000. What
is the IRR on this investment?

16,000 16,000 466,000

0   350,000   
(1  IRR ) 1
(1  IRR ) 2
(1  IRR ) 3

IRR = 12.96%

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Internal Rate of Return

Calculating IRR by using a spreadsheet

Year Cash Flow Formula

0 (350,000.00) IRR = 12.96% =IRR(B3:B7)
1 16,000.00
2 16,000.00
3 466,000.00

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Internal Rate of Return

200

150

100 IRR=12.96%
NPV (,000s)

50

0
0 5 10 15 20 25 30 35
-50

-100

-150

-200
Discount rate (%)

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Internal Rate of Return

Example
You have two proposals to choice between. The initial proposal (H)
has a cash flow that is different than the revised proposal (I). Using
IRR, which do you prefer?

16 16 466
NPV  350    0
(1  IRR ) (1  IRR )
1 2
(1  IRR ) 3

 12.96%

400
NPV  350  0
(1  IRR )1

 14.29%
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Internal Rate of Return

Example
You have two proposals to choice between. The initial proposal (H)
has a cash flow that is different than the revised proposal (I). Using
IRR, which do you prefer?

Project C0 C1 C2 C3 IRR NPV@7%

H -350 400 14.29% $ 24,000
I -350 16 16 466 12.96% $ 59,000

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Internal Rate of Return

Pitfall 1 - Mutually Exclusive Projects
 IRR sometimes ignores the magnitude of the project.

Pitfall 2 - 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.

Pitfall 3 - Multiple Rates of Return

 Certain cash flows can generate NPV=0 at two different discount
rates (if there are future negative cash flows)

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Project Interactions

When you need to choose between mutually

exclusive projects, the decision rule is
simple. Calculate the NPV of each project,
and, from those options that have a positive
NPV, choose the one whose NPV is highest.

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Mutually Exclusive Projects

Example
Select one of the two following projects,
based on highest NPV.

System C0 C1 C2 C3 NPV
Faster  800 350 350 350  118.5
Slower  700 300 300 300  87.3

assume 7% discount rate

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Investment Timing

Sometimes you have the ability:

- to defer an investment

- select a time that is more ideal at which to

make the investment decision.

A common example involves a tree farm. You may

defer the harvesting of trees. By doing so, you
defer the receipt of the cash flow, yet increase the
cash flow.

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Capital Rationing
Capital Rationing - Limit set on the amount of
funds available for investment.

Soft Rationing - Limits on available funds

imposed by management.

Hard Rationing - Limits on available funds

imposed by the unavailability of funds in
the capital market.

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Profitability Index

Profitability
Project PV Investment NPV Index
L 4 3 1 1/3 = .33
M 6 5 1 1/5 = .20
N 10 7 3 3/7 = .43
O 8 6 2 2/6 = .33
P 5 4 1 1/4 = .25

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Cash Flow vs. Accounting Income

Discount actual cash flows
Using accounting income, rather than cash flow,
could lead to erroneous decisions.

Example
A project costs $2,000 and is expected to last 2
years, producing cash income of $1,500 and $500
respectively. The cost of the project can be
depreciated at $1,000 per year. Given a 10% required
return, compare the NPV using cash flow to the NPV
using accounting income.

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Cash Flow vs. Accounting Income

Year 1 Year 2
Cash Income $1500 $ 500
Depreciation - $1000 - $1000
Accounting Income + 500 - 500

500  500
Apparent NPV =  2
 $41.32
1.10 (1.10)

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Cash Flow vs. Accounting Income

Today Year 1 Year 2
Cash Income $1500 $ 500
Project Cost - 2000
Free Cash Flow - 2000 +1500 + 500

1500 500
Cash NPV = -2000  1
 2
 $223.14
(1.10) (1.10)

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Incremental Cash Flows

Discount incremental cash flows
Include All Indirect Effects
Forget Sunk Costs
Include Opportunity Costs
Recognize the Investment in Working Capital
Beware of Allocated Overhead Costs

Incremental cash flow cash flow

Cash Flow = with project - without project

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Incremental Cash Flows

IMPORTANT
Ask yourself this question

Would the cash flow still exist if the project

does not exist?

If yes, do not include it in your analysis.

If no, include it.

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Inflation

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

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Financing Decisions

When valuing a project, ignore how the

project is financed.
Following the logic from incremental
analysis ask yourself the following
question: Is the project existence dependent
on the financing? If no, you must separate
financing and investment decisions.

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Capital Budgeting Process

Capital Budget - The list of planned investment
projects.

The Decision Process

1 - Develop and rank all investment projects
2 - Authorize projects based on:
• Legal need
• Core business
• Production efficiency
• Capacity requirements
• NPV

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Capital Budgeting Process

Capital Budgeting Problems

Consistent forecasts
Conflict of interest
Corporate politics
Forecast bias
Selection criteria (NPV and others)

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How To Handle Uncertainty

Sensitivity Analysis - Analysis of the effects
of changes in sales, costs, etc. on a project.
Scenario Analysis - Project analysis given a
particular combination of assumptions.
Simulation Analysis - Estimation of the
probabilities of different possible outcomes.
Break Even Analysis - Analysis of the level of
sales (or other variable) at which the
company breaks even.

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Sensitivity Analysis
Example
Given the expected cash flow
forecasts listed on the next
slide, determine the NPV of
the project given changes in
the cash flow components
using an 8% cost of capital.
Assume that all variables
remain constant, except the
one you are changing.

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Sensitivity Analysis
Example – continued (,000s)
Year 0 Years 1 - 12
Investment - 5,400
Sales 16,000
Variable Costs 13,000
Fixed Costs 2,000
Depreciati on 450
Pretax profit 550
.Taxes @ 40% 220
Profit after tax 330
Operating cash flow 780
Net Cash Flow - 5,400 780
NPV= $478

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Sensitivity Analysis
Example - continued

Possible Outcomes
Range
Variable Pessimisti c Expected Optimistic
Investment(000s) 6,200 5,400 5,000
Sales(000s ) 14,000 16,000 18,000
Var Cost (% of sales) 83% 81.25% 80%
Fixed Costs(000s ) 2,100 2,000 1,900

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Sensitivity Analysis
Example - continued
NPV Calculations for Pessimistic Investment Scenario
Year 0 Years 1 - 12
Investment - 6,200
Sales 16,000
Variable Costs 13,000
Fixed Costs 2,000
Depreciati on 450
Pretax profit 550
.Taxes @ 40% 220
Profit after tax 330
Operating cash flow 780
Net Cash Flow - 6,200 780
NPV= ($121)
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Sensitivity Analysis
Example - continued

NPV Possibilities
NPV (000s )
Variable Pessimistic Expected Optimistic
Investment(000s) - 121 478 778
Sales(000s ) - 1,218 478 2,174
Var Cost (% of sales) - 788 478 1,382
Fixed Costs(000s ) 26 478 930

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Scenario Analysis

Combine alternative sensitivities on the key

risk variables in your cash flow statement
and their probabilities to develop a set of
possible outcomes and probabilities.

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Flexibility & Real Options

Decision Trees - Diagram of sequential decisions
and possible outcomes.
Decision trees help companies determine their
Options by showing the various choices and
outcomes.
The Option to avoid a loss or produce extra profit
has value.
The ability to create an Option thus has value that
can be bought or sold.

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Decision Trees

Success
Test (Invest Pursue project
$200,000) NPV=$2million

Failure

Stop project

Don’t test NPV=0

NPV=0

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Real Options

1. Invest
2. Don’t Invest
3. Delay the Investment
4. Flexible Investment