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Complex Investment

This document discusses complex investment decisions faced by firms, including: choosing between investments with different lifetimes; determining the optimal time to invest or replace assets; and selecting projects under capital rationing constraints. It presents methods for evaluating long-term investments, such as calculating annual equivalent value and net present value for perpetuities. Rules are outlined for investment timing, tree harvesting problems, and using techniques like linear programming to optimize project selection when capital is limited.

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Noman Khosa
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119 views

Complex Investment

This document discusses complex investment decisions faced by firms, including: choosing between investments with different lifetimes; determining the optimal time to invest or replace assets; and selecting projects under capital rationing constraints. It presents methods for evaluating long-term investments, such as calculating annual equivalent value and net present value for perpetuities. Rules are outlined for investment timing, tree harvesting problems, and using techniques like linear programming to optimize project selection when capital is limited.

Uploaded by

Noman Khosa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Complex Investment

Decisions
Complex Investment Problems
1. How shall choice be made between investments with different lives?
2. Should a firm make investment now, or should it wait and invest later?
3. When should an existing asset be replaced?
4. How shall choice be made between investments under capital rationing?

Projects with Different Lives


The choice between projects with different lives should be made by evaluating them for equal
periods of time.

Annual Equivalent Value (AEV) Method


The method for handling the choice of the mutually exclusive projects with different lives, as discussed in
last slide, can become quite cumbersome if the projects’ lives are very long.

We can calculate the annual equivalent value (AEV) of cash flows of each project. We shall select the
project that has lower annual equivalent cost.

=
AEV for Perpetuities
When we assume that projects can be replicated at constant scale indefinitely, we imply that an annuity is
paid at the end of every n years starting from the first period.

where NPV∞ is the present value of the investment indefinitely, NPVn is the present value of the
investment for the original life, n and k is the opportunity cost of capital.

Investment Timing and Duration


The rule is straightforward:undertake the project at that point of time,
which maximizes the NPV.
Tree Harvesting Problem
The maximization of the investment’s NPV would depend on when we harvest trees. The net future value
of trees increases when harvesting is postponed; but the opportunity cost of capital is incurred by not
realizing the value by harvesting the trees. The NPV will be maximized when the trees are harvested at
the point where the percentage increase in value equals the opportunity cost of capital.

Suppose the net future value obtained over the years from harvesting the trees is At and if the opportunity
cost of capital is k, then the net present value (NPV) of the net realizable value of trees is given by:

To determine the optimum harvesting time, which maximizes the NPV, we set the derivative of the NPV
with respect to t in Equation equal to zero.

Land may have value since the trees can be replanted. Therefore, the correct formulation of the problem
will be to assume that once the trees are harvested, the land will be replanted. Thus, if we consider a
constant replication of the tree harvesting investment indefinitely, then the NPV will:

Investment Decisions under Capital Rationing


Capital rationing refers to a situation where the firm is constrained for external, or self-imposed, reasons
to obtain necessary funds to invest in all investment projects with positive NPV. Under capital rationing,
the management has not simply to determine the profitable investment opportunities, but it has also to
decide to obtain that combination of the profitable projects which yields highest NPV within the available
funds.

Why Capital Rationing


There are two types of capital rationing:

1. External capital rationing.


2. Internal capital rationing.

Profitability Index
The NPV rule should be modified while choosing among projects under capital constraint. The objective
should be to maximize NPV per rupee of capital rather than to maximize NPV. Projects should be ranked
by their profitability index, and top-ranked projects should be undertaken until funds are exhausted.
The Profitability Index does not always work. It fails in two situations:

1. Multi-period capital constraints.


2. Project indivisibility.

Programming Approach to Capital Rationing


1. Linear Programming (LP)
2. Integer Programming (IP)
3. Dual variable

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