ECONOMICS FOR MANAGERS

MANAGING LONG-TERM CAPITAL

(CAPITAL INVESTMENT DECISIONS)
THE NATURE OF INVESTMENT DECISIONS

Investment involves spending money on something that has

economic value at one point in time, which is expected to bring a
return to the investor in the future.

Capital investment decisions are those decisions where a significant

period of time elapses between the outlay and the return of the
investment.

Capital investment decision represents one of the most important

decisions:
Substantial proportion of firm's resources is involved,
It is often difficult to bail out of an investment once it has been
undertaken.

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 INVESTMENT DECISION

Investment decision for a project requires analysis of:

the future cash flows,
the degree of uncertainty associated with these future cash flows,
the value of these future cash flows considering their uncertainty.

Motivations:
Replacement,
Expansion,
Cost reduction,
Safety and environmental aspects.

Capital investment decisions are part of the capital budgeting process

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REQUIRED RATE OF RETURN

Required rate of return (RRR) is the return that owners

demand to compensate them for the time value of
money tied up in their investment and the uncertainty of
the future cash flows from that investment.
From the perspective of the business, the required rate
of return is its cost of capital.
Factors influencing the RRR:
Interest forgone
Risk premium
Inflation

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MUTUALLY EXCLUSIVE VS. INDEPENDENT
PROJECTS

Mutually exclusive projects are those projects for which

the selection of one requires the rejection of the others. In
such a scenario the best project is accepted.

Independent projects are those for which the

acceptance of one does not preclude the acceptance of
the other projects.

It is important to identify mutually exclusive projects

situation because this may affect the choice of evaluation
technique.

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 ARR PB DPB NPV PI IRR MIRR

CAPITAL BUDGETING TECHNIQUES

Average rate of return (ARR)

Payback period (PB)
Discounted payback period (DPB)
Net present value (NPV)
Profitability index (PI)
Internal rate of return (IRR)
Modified internal rate of return (MIRR)

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 ARR PB DPB NPV PI IRR MIRR

AVERAGE RATE OF RETURN

The Average Rate of Return (ARR) takes the average

(accounting) profit that the investment will generate over the life of
the investment. It is the percentage rate of return expected on an
investment, compared to the initial cost.

= × 100%

∑! " …
= × 100% input data: Net Profit
( )
∑ … −
input data: Cash Flow
= × 100%

Advantage: easy interpretation

Disadvantage: ignores the time factor
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 ARR PB DPB NPV PI IRR MIRR

AVERAGE RATE OF RETURN - CALCULATION

An investment requires an initial cost of € 6,000 and has expected cash inflows of €
1,100; 2,000; 2,500 and 1,300 for the four year period. What is the average rate of
return? Annual depreciation (SLN): € 1,500
Cash Flow Net Profit
0 (Initial Investment) -6,000
Assumption to calculate
1 1,100 -400
the Net Profit:
2 2,000 500 Revenues = Cash Flow
3 2,500 1,000 Expenses = Depreciation
4 1,300 -200
1,100 + 2,000 + 2,500 + 1,300 − 6,000
= 4 × 100%
6,000
or:
−400 + 500 + 1000 − 200 225
= 4 × 100% = × 100% = 3.75%
6,000 6,000

The average rate of return is 3.75%

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 ARR PB DPB NPV PI IRR MIRR

PAYBACK PERIOD

The Payback Period (PB or PP) is the length of time it takes to

recover the initial investment.
Payback Period allows firms to compare alternative investment
opportunities and decide on a project that returns its investment in
the shortest time, if that criteria is important to them.
For any project to be acceptable, it must fall within the maximum
PP. Where there are competing projects that meet the maximum PP
requirement, the one with the shortest PP should be selected.
Advantages:
simple to compute
easy to understand
a crude measure of liquidity
Disadvantages:
ignores the time value of money
ignores cash flows beyond the payback period
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 ARR PB DPB NPV PI IRR MIRR

PAYBACK PERIOD - CALCULATION

A project requires initial investment of € 50,000,
the net cash flows (cash inflows – cash outflows) during the following four
years are expected to be:
year Net cash flows
1 15,000
year Initial investment
2 17,500
0 50,000 3 17,500
4 16,000

Period CF Accumulated PV
1 15,000 15,000
2 17,500 32,500
3 17,500 50,000
4 16,000 66,000

The payback period for the project is 3 years

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 ARR PB DPB NPV PI IRR MIRR

DISCOUNTED PAYBACK PERIOD

The Discounted Payback Period (DPB or DPP) is the length of

time it takes to recover the initial cash flow in terms of discounted
cash flows.
For any project to be acceptable, it must fall within the maximum
DPP.
Where there are competing projects that meet the maximum DPP
requirement, the one with the shortest DPP should be selected.
Advantages:
considers the time value of money
considers risk
Disadvantages:
ignores cash flows beyond the discounted payback period
requires specifying a cost of capital

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 ARR PB DPB NPV PI IRR MIRR

DPB - CALCULATION
A project requires initial investment of € 50,000,
the net cash flows (cash inflows – cash outflows) during the following four
years are expected to be:
year Net cash flows
Interest rate: 10 % 1 15,000
@ 2 17,500
56789:;< =>8<9? =
(@ + A. @); 3 17,500
n = period 4 16,000

Period CF Discount PV Accum. PV

factor
1 15,000 0.9091 13,636 13,636
2 17,500 0.8264 14,463 28,099
3 17,500 0.7513 13,148 41,247
4 16,000 0.6830 10,928 52,175

The discounted payback period for the project is nearly 4 years.

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 ARR PB DPB NPV PI IRR MIRR

NET PRESENT VALUE

The Net Present Value (NPV) is the present value of the net cash
inflows less the project´s initial investment outlay.

NPV = PV of cash inflows - PV of cash outflows

D

!"B = C Advantages:
1+  considers the time value of money
E
 considers risk
 For any project to be acceptable,  considers all cash flows of the
the NPV must be positive. investment opportunity
 objective decision criteria
 Where there are competing projects
with positive NPVs, the one that Disadvantages:
gives the highest positive NPV  requires specifying a cost of capital
should be accepted.
13
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 ARR PB DPB NPV PI IRR MIRR

NET PRESENT VALUE

A project requires initial investment of € 50,000,
the net cash flows (cash inflows – cash outflows) during the following four
years are expected to be:
year Net cash flows
Interest rate: 10 % 1 15,000
@ 2 17,500
56789:;< =>8<9? =
(@ + A. @); 3 17,500
n = period 4 16,000

Period CF Discount factor PV

0 - 50,000 1.0000 - 50.000
1 15,000 0.9091 13,636
2 17,500 0.8264 14,463
3 17,500 0.7513 13,148
4 16,000 0.6830 10,928
Σ = NPV 2,175
14
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 ARR PB DPB NPV PI IRR MIRR

PROFITABILITY INDEX

Profitability Index (PI) is a variation of the NPV.

The present value of the future cash flows divided by the initial
investment.
Advantages:
"B F ℎ H  considers all cash flows
" =
F  considers risk
 considers the time value of money
 useful when ranking and selecting
projects when capital is rationed
 If the profitability index is less
Disadvantages:
than 1, the investment should  difficult to interpret
be rejected.  requires specifying a cost of capital

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 ARR PB DPB NPV PI IRR MIRR

PROFITABILITY INDEX
Initial investment: € 50,000
Expected cash flows for the first four years: year Net cash flows
1 15,000
Interest rate: 10 %
@ 2 17,500
56789:;< =>8<9? =
(@ + A. @); 3 17,500
n = period 4 16,000

Period CF Discount factor PV

Initial Investment - 50,000
1 15,000 0.9091 13,636
2 17,500 0.8264 14,463
3 17,500 0.7513 13,148
4 16,000 0.6830 10,928
Σ 52,175

52,175
" = = 1.04
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50,000 16
 CAPITAL RATIONING
Capital rationing is a situation in which there is a limit on the capital
budget.
Capital rationing requires looking at all possible combinations of
projects to find the combination that maximizes owners’ wealth.
Capital rationing may result in rejecting profitable projects.

The finance manager at XYZ Co. has to determine which projects should the
company undertake when the capital budget is limited to €1,000,000
Project Initial Investment Present Value Profitability Index
A 400,000 500,000 1.125
B 1,100,000 1,430,000 1.300
C 450,000 486,000 1.080
D 600,000 564,000 0.940
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 ARR PB DPB NPV PI IRR MIRR

INTERNAL RATE OF RETURN

The Internal Rate of Return (IRR) is the effective yield on the

project; that is, the discount rate that causes the net present value
to be equal to zero.
It is the true interest rate earned on an investment over the course
of its economic life.

C =0
(1 + )
E

 For any project to be acceptable, it must meet the minimum IRR

requirement.
 Where there are competing projects, the one with the highest IRR
should be selected.
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 ARR PB DPB NPV PI IRR MIRR

INTERNAL RATE OF RETURN

Linear Interpolation Advantages:

 considers the time value of
money
= + ×( J − )  considers risk (in the decision
+ I rule)
 considers all cash flows
 objective decision criteria
p1= % by positive NPV Disadvantages:
p2= % by negative NPV  no unique IRR if there is more
A = positive NPV (by % p1) than one sign change in cash
B = negative NPV (by % p2) flows
 requires specifying a cost of
capital

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 ARR PB DPB NPV PI IRR MIRR

INTERNAL RATE OF RETURN

Investment: € 50,000
Expected cash flows for the first four years: year Net cash flows
1 15,000
If p = 10 %, the NPV is positive. 2 17,500
3 17,500
Therefore, the IRR > 10 %.
4 16,000

= + ×( J − )
+ I
2175
= 10% + × (20% − 10%) = 11.97
2175 + −7504
p1=% by positive NPV (10 %)
p2=% by negative NPV (20 %)
A = positive NPV (by % p1)
B = negative NPV (by % p2)
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 ARR PB DPB NPV PI IRR MIRR

INTERNAL RATE OF RETURN

 Investment: € 50,000
 Expected cash flows for the first four years: year Net cash flows
1 15,000
 Interest rate: 11.97% 2 17,500
@ 3 17,500
56789:;< L>8<9? =
(@ + A. @@MN); 4 16,000

Period CF DF 11,97 % DCF

0 - 50,000 1.0000 -50,000
1 15,000 0.8931 13,396
2 17,500 0.7976 13.958
3 17,500 0.7124 12.466
4 16,000 0.6362 10.179
NPV 0

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 ARR PB DPB NPV PI IRR MIRR

MODIFIED INTERNAL RATE OF RETURN

The Modified Internal Rate of Return (MIRR) is the effective yield on the
project if intermediate cash flows are reinvested at a specified rate (usually the
project's cost of capital).
MIRR reflects the cost and profitability of a project more accurately.
Solving requires two steps:
Step 1: Calculate the terminal (future value)
P B
Step 2: Solve for the rate: if FV = PV(1+MIRR)n, then: O = −1
"B
Advantages:
 considers the time value of money
 considers risk
 considers all cash flows
 objective decision criteria
Disadvantages:
 difficult to interpret
 requires specifying the reinvestment rate
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 ARR PB DPB NPV PI IRR MIRR

MODIFIED INTERNAL RATE OF RETURN

Initial investment: € 50,000

Expected cash flows: € 15,000, € 17,500, € 17,500 and € 16,000
Suppose there are no reinvestment possibilities (that is, reinvestment rate = 0%)
0 1 2 3 4
time

-50,000 15,000 17,500 17,500 16,000

17,500
17,500
15,000
66,000
PV = 50,000; FV = 66,000; n = 4

Q 66,000
If FV = PV(1+MIRR)n, then: O = − 1 = 0.0719
50,000

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 ARR PB DPB NPV PI IRR MIRR

MODIFIED INTERNAL RATE OF RETURN

Initial investment: € 50,000
Expected cash flows: € 15,000, € 17,500, € 17,500 and € 16,000
Suppose reinvestment rate is 5%
0 1 2 3 4
time

-50,000 15,000 17,500 17,500 16,000

18,375 = 17,500 x (1.05)1
19,294 = 17,500 x (1.05)2
17,364 = 15,000 x (1.05)3
71,033
PV = 50,000; FV = 71,033; n = 4

Q 71,033
If FV = PV(1+i)n, then: O = − 1 = 0.0917
50,000

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i = MIRR = 9.17% 24
 ARR PB DPB NPV PI IRR MIRR

MODIFIED INTERNAL RATE OF RETURN

Initial investment: € 50,000
Expected cash flows: € 15,000, € 17,500, € 17,500 and € 16,000
Suppose reinvestment rate is 11.97%
0 1 2 3 4
time

-50,000 15,000 17,500 17,500 16,000

19,595 = 17,500 x (1.1197)1
21,940 = 17,500 x (1.1197)2
21,057 = 15,000 x (1.1197)3
78,592
PV = 50,000; FV = 78,592; n = 4

Q 78,592
If FV = PV(1+i)n, then: O = − 1 = 0.1197
50,000

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i = MIRR = 11.97% 25
 INVESTMENT PROFILE

The Investment Profile (also referred to as the NPV profile) is

the illustration of a project’s NPV at various discount rates.

Initial cost: € 50,000

expected cash flows: € 15,000, € 17,500, € 17,500 and € 16,000

Investment Profile
Discount Discounted NPV
20000
(%) inflows
15000
0 66,000 16,000
5 58,439 8,439 10000

10 52,175 2,175 5000

15 46,931 -3,069 0
0% 5% 10% 15% 20%
20 42,496 -7,504 -5000

-10000
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 DETERMINING THE CROSS-OVER RATE FOR
MUTUALLY EXCLUSIVE PROJECTS
Cross-over rate is discount rate at which the net present values of two
projects are equal; the internal rate of return of the differences in the
cash flows of two projects.
Step 1: Calculate the difference in the projects’ cash flows for each
period.
Step 2: Calculate the IRR of the differences. This is the cross-over rate.
Period CF A CF B
0 -1,500 -1,000
Determining the cross-
1 +450 +500
over rate for mutually
exclusive projects 2 +550 +400
(project A and B) 3 +650 +350
4 +650 +200
Cost of capital: 15%
NPV 106.2 81.7
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IRR 18.2 % 19.6 27
%
 DETERMINING THE CROSS-OVER RATE FOR
MUTUALLY EXCLUSIVE PROJECTS
(PROJECTS A AND B)

Period CF A CF B Difference
0 -1,500 -1,000 -500
1 +450 +500 -50
2 +550 +400 +150
3 +650 +350 +300
4 +650 +200 +450
The IRR of the differences is 16.6 %

Project evaluation (investment profile) at several discount rates

NPV 0.0 % 10.0 % 16.6 % 19.0 %
A 800 296 52 -24
B 450 185 52 10
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 THE PROCESS OF INVESTMENT
DECISION MAKING
Determine investment funds available
Capital rationing
Identify profitable project opportunities
Define and classify proposed project(s)
Evaluate proposed project(s)
Approve project(s)
Monitor and control the project(s)

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COST-BENEFIT ANALYSIS

A cost-benefit analysis (CBA) is a systematic process that

businesses use to analyse which decisions to make and which to
give up.
The CBA includes measurable financial data, such as revenues
generated or costs saved as a result of project implementation, but
also intangible benefits and costs or effects of decisions, such as
opportunity costs, customer satisfaction, etc.
Benefit-Cost Ratio
the overall relationship between the relative costs and benefits of a
proposed project
∑ "B S F TU
I =
∑ "B F TF

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 COST-BENEFIT ANALYSIS

A project requires an initial investment of € 50,000, the cash flows during the
following four years are expected to be:

Cash inflows Cash outflows

1 € 60,000 € 45,000
2 € 62,500 € 45,000
3 € 62,500 € 45,000
4 € 62,500 € 46,500 Benefit Benefit Cost
tax additional opportunity
Interest rate: 10%. savings income cost
Additional information for the CBA:
Method of depreciation: SLN (4 years)
Tax rate: 20%
Expected sale of fully depreciated asset: € 3,000
The asset will be located in a production hall at a place that is currently
rented by another company as a storage space. This contract will have to be
terminated. The annual rent is € 4,000
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 COST-BENEFIT ANALYSIS
Benefits
CF (+) Tax savings sale Benefits PV (10%)
1 60,000 2,500 62,500 56,818
2 62,500 2,500 65,000 53,719
3 62,500 2,500 65,000 48,835
4 62,500 2,500 3,000 68,000 46,445
Σ 205,818
Costs
CF (-) Opportunity Costs PV (10%)
cost
1 45,000 4,000 49,000 44,545
2 45,000 4,000 49,000 40,496
3 45,000 4,000 49,000 36,814
4 46,500 4,000 50,500 34,492
Σ 156,348

∑ "B S F TU 205,818
I = = = 0.9894
∑ "B F TF 50,000 + 156,348
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