Topic 1: Project Evaluation Methods.

 Other project evaluation methods: e.g payback, discount payback, , accounting rate of return and
modified internal rate of return.

 Break
Even sensitivity analysis

Intended learning outcomes as a result of taking this course, you should be able to:

• Identify the principles that underlie corporate finance.

• Identify the characteristics of a good decision-making objective, and understand the conflicts between wealth
maximization and alternative objectives.
a. Three fundamental principles that underlie corporate finance

Answer: 1st Principle: The Investment Principle: Invest in assets/projects that yields returns which are greater than
the minimum acceptable cost of capital. The return reflects the size and the timing of the cash flows. The cost of
capital reflects the risk of the investment and capital mix used.

2nd Principle: The financing Principle: Choose the capital structure (debt and/or equity) which maximizes the value of
the investment made and choose the financing type which matches to characteristic of the investment/project
undertaken. For example, stable long-term debt financing is better suited for the long term projects like
infrastructure projects because it matches the duration of the assets. On the other hand, equity financing is more
appropriate for projects with shorter life span. It's all about finding the right balance that enhances the overall value
of your business.

3rd Principle: The Dividend Principle: If there are not enough investment opportunities which cannot earn returns
enough to cover minimum cost of capital, then return the cash by way of dividend distribution or share repurchases,
to the owners of the business.

The above three principles of corporate finance, helps to focus on maximization of the firm’s value. Firms can make
right investment, financing and payout decisions.

b. Decision-making objectives of stock price maximization.

Answer 1: The decision-making objective of stock price maximization focuses on actions and strategies that aim to
increase the value of a company's stock in the financial markets. Here are some key points related to this objective:

Optimizing Financial Performance: Companies strive to enhance their financial performance, as reflected in key
financial metrics like revenue growth, profitability, and return on investment. Positive financial indicators are often
associated with a higher stock price.

Effective Capital Structure Management: Maintaining an optimal capital structure that balances debt and equity to
maximize shareholder value. Investors typically react positively to companies with efficient and sustainable capital
structures.

Strategic Investments and Growth Initiatives: Making strategic investments and pursuing growth opportunities that
are expected to generate positive returns. Investors are more likely to value companies that demonstrate a clear and
effective growth strategy.

Transparent and Effective Communication: Ensuring transparent communication with shareholders and the financial
community. Clear and accurate information helps in building trust and confidence among investors, potentially
leading to a positive impact on the stock price.

Dividend Policy: While stock price maximization is the primary focus, decisions regarding dividend payouts are made
with care. Some investors prefer companies that distribute profits as dividends, while others may prefer
reinvestment for future growth.

Risk Management: Implementing effective risk management strategies to mitigate potential risks that could
negatively impact the stock price. Investors often appreciate companies that demonstrate a proactive approach to
risk.

Corporate Governance and Ethical Practices: Maintaining high standards of corporate governance and ethical
practices. Companies that prioritize these aspects may be viewed more favourably by investors, positively influencing
the stock price.

It's important to note that while maximizing stock price is a common objective, it should be pursued ethically and in
alignment with the long-term sustainability and success of the business. Short-term measures that artificially inflate
stock prices without underlying value creation may not be in the best interest of the company or its stakeholders in
the long run.
Why focus on stock price maximization?

Answer2: In the corporate world, the primary goal is to maximize the overall value of the business, taking into
account both existing assets and potential growth assets. Any decision—be it related to investments, financing, or
payouts—that increases the overall value of the business is considered favourable. This objective is broader and less
restrictive. It allows for a more holistic approach, considering all aspects that contribute to the overall value of the
business.

A more specific and narrower goal is to maximize the wealth of the stockholders and it is closely linked to the
broader objective of maximizing the value of the firm. Here's how stock price maximization is connected to the
overall efficiency and success of a business:

Market Perception of Value: The stock price is a reflection of how the financial markets perceive the value of a
company. When the stock price increases, it often indicates that investors believe the company is creating value and
has strong growth prospects.

Efficient Capital Allocation: A rising stock price can suggest that the company is making effective decisions in
allocating capital. It implies that investments and projects undertaken by the company are viewed positively by
investors, contributing to overall business efficiency.

Shareholder Wealth Maximization: Maximizing stock price directly aligns with the goal of maximizing shareholder
wealth. Shareholders, as owners of the company, benefit when the stock price increases. This, in turn, can attract
more investors and support from the financial community.

Access to Capital: A higher stock price can make it easier for a company to raise additional capital through equity
offerings. This is because investors may be more willing to invest in a company with a strong stock performance,
providing the firm with financial flexibility for growth initiatives.

Employee and Management Incentives: Stock based compensation to employees and management like ESOP. When
employees and executives have a stake in the company's stock, it can align their interests with those of shareholders,
fostering a focus on actions that enhance stock value.

While stock price maximization is not only a valuable indicator of business efficiency, but also most easily observable
of all the financial measures to judge the performance of the publicly traded firm. However, it's essential to note that
it is not the sole measure of a company's success. It should be considered in conjunction with other financial metrics
and indicators. Additionally, a focus solely on short-term stock price gains at the expense of long-term value creation
may not be sustainable. Companies should aim for strategies that lead to both short-term stock price growth and
long-term value generation.

c. Assumptions that must hold for the objective of stock price maximization

Answer:

Assumptions that underlie the goal of maximizing stock price:

Efficient Markets: The efficient market hypothesis suggests that stock prices fully reflect all available information. In
other words, it assumes that stock prices are always accurate and instantly adjust to new information, making it
difficult to consistently outperform the market.

Rational Investors: Investors are assumed to be rational decision-makers. This means they make investment
decisions based on all available information and aim to maximize their own utility or wealth. Rational behaviour is
crucial for the efficient functioning of financial markets.

No Market Frictions: The absence of market frictions such as transaction costs, taxes, or restrictions on short selling
is often assumed. In a frictionless market, investors can buy and sell securities without incurring significant costs,
allowing for smooth price adjustments.
Homogeneous Expectations: Investors share homogeneous expectations regarding the future prospects of a
company. This implies that there is a consensus among investors about the expected future cash flows, risks, and
growth potential of a firm.

No Agency Issues: Agency problems, such as conflicts of interest between management and shareholders, are
assumed to be minimal. This assumes that management acts in the best interest of shareholders and makes
decisions that maximize shareholder wealth.

It's important to note that these assumptions are theoretical and may not always hold in real-world situations.
Market inefficiencies, behavioral biases, and agency problems are common in practice. Therefore, while the objective
of stock price maximization is a guiding principle, decision-makers should consider the real-world complexities and
dynamics of financial markets.

d. Real-world conflicts of interest

The debate over the objective of maximizing value in corporate finance often revolves around whether the focus
should be on maximizing the value of stockholders' stake specifically or the value of the entire business, which
includes other stakeholders like debtholders. Additionally, there's a question about whether maximizing stockholder
wealth directly translates into maximizing the stock price.

Let's break down the discussion into following key points:

Maximizing Value for Stockholders vs. Entire Business: Some theorists argue for maximizing the value of the
stockholders' stake, while others advocate for considering the value of the entire business, which includes both
stockholders and debtholders. The choice between these objectives often depends on the assumptions made
regarding factors like market efficiency, the role of debt, and the impact on different stakeholders.

Maximizing Stockholder Wealth and Stock Price: There's a question about whether maximizing stockholder wealth
is equivalent to maximizing the stock price. While an increase in stock price generally benefits stockholders, the
relationship may not always be straightforward due to factors like dividends and market perceptions.

Risks and Conflicts of Interest: Focusing on maximizing stock price can lead to conflicts of interest among various
stakeholders, including managers, stockholders, and bondholders.

What benefits one group of stakeholders may not align with the interests of others. For instance, decisions that
benefit managers may not be in the best interest of stockholders, and actions favorable to stockholders may not
align with the interests of bondholders.

Broader Social Costs: Corporate finance decisions, especially those aimed at maximizing stock price, may have
externalities and costs for society at large. What benefits the firm or its stakeholders might not always align with
broader societal well-being.

Risk Exposure: The exclusive focus on stock price maximization exposes corporate finance to risks, and decisions
made solely to boost stock prices may not be aligned with long-term sustainability and ethical considerations.

Striking a balance that considers the interests of different stakeholders, ethical considerations, and long-term
sustainability is often a complex task.

e. Potential alternatives to stock price maximization

While stock price maximization is a common objective in corporate finance, there are alternative objectives that
firms may consider, depending on their values, industry, and long-term goals. Here are some potential alternative
objectives:

Profit Maximization: Focus on maximizing profits, either in terms of total profits or profit margins. This objective
emphasizes the financial performance and profitability of the firm.
Revenue Growth: Emphasize increasing revenue and market share. This objective is particularly relevant for firms in
industries where rapid growth and capturing market share are critical.

Customer Satisfaction and Loyalty: Prioritize customer satisfaction and loyalty. The idea is to create long-term
relationships with customers, leading to repeat business and positive word-of-mouth.

Employee Welfare and Well-being: Concentrate on employee welfare, development, and well-being. This includes
fair compensation, opportunities for growth, and a positive work environment.

Environmental and Social Responsibility: Incorporate environmental and social responsibility into business practices.
This includes sustainable and ethical business operations, minimizing environmental impact, and contributing
positively to society.

Firms often combine multiple objectives to create a comprehensive approach that aligns with their values and
business model. The choice of objectives depends on various factors, including the industry, competitive landscape,
and the firm's vision for the future.

f. Understand the fundamentals of project evaluation and be able to calculate net present value, internal rate of
return, payback period, and accounting rate of return.

f.i. Notes:

o Projects with a positive NPV add to wealth and should be accepted.

o Projects with a negative NPV reduce wealth and should be rejected.

Two equivalent decision rules for capital investment:

o Net present value rule: Accept investments that have positive NPV.
o Rate of return rule: Accept investments that offer rate of return in excess of their opportunity cost of capital.

f.ii Separation Principle: Security transactions in a normal market neither create nor destroy value on their own.
Therefore, we can evaluate the NPV of an investment decision separately from the decision the firm makes regarding
how to finance the investment.

f.iii For Project Evaluation : Repractise Exc Lect 1 Question no 4. Some formulas used in the question:
(1+Real Rate) = (1+nominal rate)*(1+inflation rate) and
Please note: The discount rate is the rate used to calculate the present value of future cash flows. Typically, we use a
company's cost of capital or required rate of return on projects.

The issue arises when the cash flows from a project or investment are expected to experience inflation each year. If
we use the regular discount rate of 9.2%, we would be over-discounting or penalizing those cash flows that actually
see higher nominal returns due to inflation.

So instead, we calculate an adjusted discount rate specific to each cash flow stream based on its inflation rate.

The formula is:

Adjusted Discount Rate = (1 + Nominal Rate) / (1 + Inflation Rate) – 1

Use the above adjusted Discount Rate to calculate annuity discount factor.

f.iv Sunk Cost: Is the cost for which company is liable irrespective of the decision about whether to proceed or not to
proceed with the project.

Opportunity Cost: The value/CFs obtained from the resources alternative use, if the project is not being undertaken.

Side Effects: Project externalities like sales erosion are indirect effects of undertaking the project, that may increase
or decrease the profits of other business activities of the firm.
Allocated Cost: Overhead expenses are associated with activities that are not directly attributable to a singal
business activity but are allocated to different business activities for accounting purpose. Only increases in
overhead expenses resulting from the project are included.

Depreciation Expenses: Don’t involve cash flows and are thus irrelevant. Become relevant when it reduces the firm’s
taxable profit.

Investment Decisions:

Based on Profitability Index: According to the PI decision rule, a project should be accepted if its PI is greater than
one and rejected if it is less than one. (PV of its expected cash flows/initial cash outlay.)

The Profitability Index (PI) may lead to an incorrect decision when applied to two mutually exclusive investments
(meaning you can only choose one) with different initial cash outlays. PI with lower initial outlay may be higher than
other project with higher initial outlay. It is recommended to use PI as an additional decision making tool for project
evaluations along with other project evaluation methods like NPV Methods, IRR.

Internal Rate of Return is the discount rate that makes the NPV of a project equal to zero. According to the IRR
decision rule, an investment should be accepted if its IRR is higher than its cost of capital and should be rejected if its
IRR is lower.

Similar to the NPV, the IRR takes into account the time value of money and the investment risk. The risk of an
investment does not enter in to the computation of its IRR, but through the comparison of the investment’s IRR with
its cost of capital. However, a) the IRR rule is only guaranteed to work for a stand-alone project if all of the project’s
negative cash flows precede its positive cash flows. Otherwise, multiple IRR may exist or no IRR may exist. Further,
when projects differ in their scale of investment, the timing of their cash flows or their riskiness, then their IRRs
cannot be meaningfully compared. (Would you prefer a 500% return on £1 or a 20% return on £1 million?)

Payback Period: Payback period evaluates projects on the number of years to pay back the capital. It ignores the
time value of money. It ignores cash flows after the capital is paid off. According to the payback period rule, a
project is acceptable if its payback period is shorter than or equal to a specified number of periods called the cutoff
period.

NPV is considered to be the best criterion for project evaluation because it provides a direct measure of the value a
projects add to shareholder wealth.

Important:

Net Present Value:

Advantages Disadvantages
Incorporates the time value of the money, The NPV decision rule is dependent on the
providing a realistic assessment of the project’s selection of an appropriate discount rate. Small
profitability. changes in the discount rate can affect the NPV
outcome.
Consider all cash flows over the project’s life. NPV is an absolute measure of the profitability
of an investment project. (It represents the net
increase in enterprise value or wealth
generated by the project, calculated by
subtracting the initial investment cost from the
present value of expected cash inflows.) NPV
does not provide a relative measure, and a
large investment may have a higher NPV but a
lower return on investment (ROI)
As per the decision rule, project may be May be complex to calculate NPV for projects
accepted if NPV is positive. It reflects a with irregular cash flows.
commitment to the goal of maximizing
shareholder wealth by accepting projects that
are expected to enhance the enterprise value.
 Profitability Index
Provides a ratio that helps assess the relative Similar to NPV, requires a discount rate
profitability of projects. assumption.
Useful for ranking projects when capital is Doesn't give a clear indication of the project's
constrained. actual profitability in monetary terms.

Internal Rate of Return (IRR)

Considers the Time Value of Money. The IRR rule is only guaranteed to work for a
stand-alone project if all of the project’s
negative cash flows precede its positive cash
flows. Otherwise, multiple IRR may exist or no
IRR may exist.
Offers a percentage rate of return, making it When projects differ in their scale of
easy to communicate. investment, the timing of their cash flows or
their riskiness, then their IRRs cannot be
meaningfully compared. (Would you prefer a
500% return on £1 or a 20% return on £1
million?)
Useful for comparing projects against a
required rate of return.

Payback Period
Simple and easy to understand. Ignores the Time Value of Money.
Provides a quick assessment of the time it takes Doesn't consider cash flows beyond the
to recover the initial investment. payback period.
Ignores profitability and focuses only on the
time to recover the initial investment.
Profitable projects with a longer payback
period might be overlooked or deemed less
favourable under the Payback method, even if
they generate significant profits in the later
years.

(Practise writing pros and cons on a sheet)

Why Companies should use multiple evaluation methods rather than just one of them?

Answer: Using multiple evaluation methods for assessing projects is a prudent approach in financial decision-making.
Each evaluation method has its strengths and weaknesses, and employing a variety of methods provides a more
comprehensive and robust analysis. By using multiple approaches, you can also cross-validate your findings, helping
to mitigate the impact of any potential biases or inaccuracies in a single method.

Exc Lec 2 Q1.d. How you could incorporate corporate tax into the investment appraisal?

Answer: Incorporating corporate taxes into investment appraisal is essential for a more accurate assessment of a
project's financial viability. Following are some of the ways to consider corporate tax in project evaluation:

Tax Shield on Depreciation and Interest: Depreciation is a non-cash expense that reduces taxable income and
therefore provides tax shield. If the project involves financing through debt, then interest expense can also provide a
tax shield.

The tax shield is the amount of tax saved due to the depreciation and Interest expenses. Calculation of free cash flow
taking Tax shield benefits

(Revenues – Cost – Depreciation – Interest (1-Tc)) * (1-Tc) + Depreciation - Capital Expenditure – Change in Net
Working Capital.
Terminal Value and Salvage Value: When calculating the terminal value or salvage value, apply the corporate tax
rate to any gains or losses. This is particularly relevant for assets sold or disposed of at the end of the project's life.

Sensitivity Analysis with Tax Rates: Conduct sensitivity analysis by varying the corporate tax rate to assess the
project's robustness under different tax scenarios.

Discount Rate Adjustment: Discount rate used in the NPV calculation should reflect the after-tax cost of capital.
Therefore, we can adjust the cost of capital by considering the corporate tax rate.

By adjusting free cash flows, cost of capital to incorporate corporate tax, we can bring more accurancy in our
project’s evaluation process.

Exc Lec 2 Q1.e. Describe the payback and accounting rate of return methods of investment appraisal and discuss why
the discounted cash flow (DCF) method is preferable?

Answer: The payback method is a straightforward technique that assesses how long it takes for an investment to
recover its initial cost. While the payback method is easy to understand and provides a quick measure of liquidity, it
has significant limitations. It ignores the time value of money, does not consider cash flows beyond the payback
period, and may not account for the profitability of the investment.

The accounting rate of return measures the profitability of an investment by dividing the average accounting profit
by the average investment. While it is simple to calculate and uses accounting data, ARR has drawbacks. It relies on
accounting profit, which can be manipulated by accounting methods, and does not consider the time value of
money.

The discounted cash flow (DCF) methods are considered superior due to its ability to address the limitations of
payback and ARR. DCF incorporates the time value of money by discounting future cash flows to present value using
a chosen discount rate (such as the cost of capital). It provides a more accurate assessment of a project's profitability
and considers the entire cash flow timeline. Key DCF metrics include Net Present Value (NPV) and Internal Rate of
Return (IRR).

g. Evaluate strategic options to delay, expand, or contract.

Exc Lect 2 – Q2 (b) How the presence of strategic investment options affects the decisions to adopt long-term over
short-term investments?

Strategic investment options play a pivotal role in shaping business decisions, especially when it comes to choosing
between long-term and short-term investments. Strategic options serve as a prudent mechanism for decision-
making, enabling businesses to assess the robustness of their plans across various scenarios. This prudence is
essential for making informed choices that align with long-term objectives. This approach enhances risk
management processes, allowing companies to identify and mitigate potential challenges that may arise over time.

Short term investments might overlook long-term profitability, while longer term investments may increase the risk
of financial distress. By considering factors like risk tolerance and industry-specific challenges, businesses can strike a
balance between short-term gains and long-term sustainability. Long-term investments, when carefully evaluated
through strategic options, can help mitigate the risk of financial distress. Balancing the benefits of long-term
profitability with the potential challenges ensures a more resilient and sustainable business model. In conclusion,
carefully curated strategic investment options fortifies the investments from any downturn.