LONG TERM

INVESTMENT

Advanced Financial
Management

Te n k i r S e i f u , P h D 2/1/20XX 1
 Chapter objectives

After completing this chapter,

you should be able to:
Apply project modelling
that include explicit
Evaluate the potential value treatment for: Establish the potential
added to a company arising economic return (using
• Inflation and specific price variation Discuss the relative merits
from investment project internal rate of return (IRR)
• Taxation of NPV and IRR
using the net present value • capital rationing.
and modified internal rate
(NPV) model. • Project duration as a measure of of return)
risk.
 Long-term Investment
Decision

► The process of identifying, analyzing, and

selecting investment projects whose
returns (cash flows) are expected to
extend beyond one year.
Importance of Long-term Investment

Capital budgeting decisions are of paramount

importance in financial decision making,

First, the fixed assets are the true earning assets of

the firm. Thus, capital budgeting decisions determine
the future destiny of a firm.

Secondly, capital expenditure decisions has its effect

over long time span and involve a large amount of
expenditure
 The Long-term Investment
Decision Process

1 2 3 4 5

Generate Estimate Evaluate Select Reevaluate

investment after-tax project projects implemented
proposals incremental incremental based on investment
operating cash flows. acceptance projects
cash flows criterion.
 A key concept in
investment appraisal
– Free cash flow

► It represents cash flow available:

▪ to all the providers of capital of a
company
▪ to pay dividends or finance additional
capital projects.
► Free cash flows are used frequently in
financial management:
▪ as a basis for evaluating potential
investment projects
▪ as an indicator of company
performance
▪ to calculate the value of a firm and
thus a potential share price
 • Initial Investment: an outlay of cash
that takes place at the beginning of
the life of the project..
• Operating cash flows: cash inflows
Components of from revenue and the cash out flows
project Cash for different expenditures, during the
Flows project life after the initial
investment.
• Terminal cash flows are the cash
inflows and out flows that take place
at the end of the project life
 Initial Cash Outflow
a) Cost of “new” assets
b) - Investment tax credit
c) + (–) Increased (decreased) NWC
d) – Net proceeds from sale of
“old” asset(s) if replacement
e) + (–) Taxes (savings) on the sales
of “old” asset(s) if replacement
= Initial cash outflow
 Operating net Cash Flows
► Net operating cash flow is equal net income
plus non cash operating expenses minus non-
cash operating revenues
► The net Operating cash flow will be
determined as follows:
After-tax cash revenues xxx
Less: after-tax cash expenses xxx
Net operating cash flow xxxx
 Terminal Cash Flows
►The terminal cash flows are those cash flows
associated with end of the project.
►Terminal cash flow include:
►The salvage proceeds from the sale of assets,
net of the relevant income taxes.
►The recovery of net working capital at the end
of the projects life. The increase in the net
working capital at the time of investment is
expected to be recovered when the project
terminates.
 Example …
►A company is considering the purchase of a new
machine. The machine will cost $50,000 plus $10,000 for
shipping and installation and has useful life of 4 years and
will then be sold (scrapped) for $10,000 at the end of the
fourth year. If the machine is purchased:
► NWC will rise by $5,000.
►Revenues will increase by $110,000 and
►Operating costs (excluding depreciation) will rise by
$70,000 for each year for the next four years.
►The company is in the 30% tax bracket. Assume
straight line method for depreciation.
 Example …
Compute :
A)The initial cash flow
B)Net Operating cash flow
C)Terminal cash flow
 Summary of Project Net
Cash Flows
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
–$65,000* $31,750 $31,750 $31,750 $46,750

* Notice again that this value is a negative cash

flow as we calculated it as the initial cash
OUTFLOW.
 ►The following investment appraisal
methods incorporate the use of
free cash flows:
1.Net Present Value (NPV)
Use of free 2. Internal Rate Of Return (IRR)
cash flows in 3.Modified Internal Rate Of Return
(MIRR)
investment 4.Discounted Payback Period
appraisal 5.Duration (Macaulay Duration and
Modified Duration)
6.Profitability Index (PI)
 The Net Present Value Method
► Capital investment projects are best evaluated using the net
present value (NPV) technique..
► The net present value (NPV) is the difference between the
present value of the cash inflows and outflows associated
with a project.

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 Net Present Value
(continued)

►Once the NPV for a project is computed, it can be

used to determine whether or not to accept an
investment.
►A positive NPV, the project shall be accepted.
►If the NPV equals zero, the decision maker will
find acceptance or rejection of the investment
indiferent.
►If the NPV is less than zero, the investment should
be rejected. In this case, it is earning less than the
required rate of return.
 Example

Information:
A detailed market study revealed expected annual revenues of
$300,000 for new earphones. Equipment to produce the earphones
will cost $320,000. After five years, the equipment can be sold for
$40,000. In addition to equipment, working capital is expected to
increase by $40,000 because of increases in inventories and
receivables. The firm expects to recover the investment in working
capital at the end of the project’s life. Annual cash operating
expenses are estimated at $180,000. The required rate of return is
12 percent.
Required:
Estimate the annual cash flows and calculate the NPV. Ignore tax.
Example: Solution
Example: solution …
 ►Some basic points that
must be understood in
relation to NPV are
▪ Relevant cash flows
Some basic NPV ▪ Discounting
concepts ▪ Impact of inflation
▪ Impact of taxation
 Relevant costs and
revenues

► Relevant cash flows are those

costs and revenues that are:
▪ Future
▪ incremental.
► You should, therefore, ignore:
▪ sunk costs
▪ committed costs
▪ non-cash items
▪ apportioned overheads
Discounting
 Impact of inflation
►In times of inflation, the fund providers will require a return made up of
two elements:
▪ Real return for the use of their funds.
▪ Additional return to compensate for inflation.
►The overall required return is called the money or nominal rate of return.
►Real and nominal rates are linked by the Fisher formula
(1 + 𝑖) = (1 + 𝑟)(1 + ℎ)
Where,
r = real rate
i = money/nominal interest rate
h = general inflation rate.
 Impact of inflation
In investment appraisal two types of inflation need consideration:
 Calculating the free cash flows of a project under inflation
► In project appraisal the impact of inflation must be considered when calculating the free cash flows to
be discounted.
► The impact of inflation can be dealt with in two different ways – both methods give the same NPV.
 Illustration
► A company is considering investing $4.5m in a project to achieve an annual increase in
revenues over the next five years of $2m.
► The project will lead to an increase in wage costs of $0.4m pa and will also require
expenditure of $0.3m pa to maintain the level of existing assets to be used on the project.
► Additional investment in working capital equivalent to 10% of the increase in revenue will
need to be in place at the start of each year.
► The following forecasts are made of the rates of inflation each year for the next five years:
▪ Revenues 10%
▪ Wages 5%
▪ Assets 7%
▪ General prices 6.5%
► The real cost of capital of the company is 8%.
► All cash flows are in real terms. Ignore tax.
Required: Find the free cash flows of the project and determine whether it is worthwhile
Solution
 The impact of taxation
►Tax charged on a company’s profits is a relevant cash flow for
NPV purposes.
►It is assumed that:
▪ operating cash inflows will be taxed at the corporation tax rate
▪ operating cash outflows will be tax deductible and attract tax relief at
the corporation tax rate
▪ investment spending attracts tax allowable depreciation which gets
tax relief
▪ the company is earning net taxable profits overall
 ► A company buys an asset for $26,000. It
will be used on a project for three years
after which it will be disposed of on the
final day of year 3 for $12,500.
► Tax is payable at 30%. Tax allowable
depreciation is available at 25% reducing
balance, and a balancing allowance or
charge should be calculated when the
asset is sold.
► Net trading income from the project is
Exercise

$16,000 p.a. and the cost of capital is 8%.

► Required: Forecast the free cash flows of
the project and determine whether it is
worthwhile using the NPV method
 Internal Rate of Return
► The internal rate of return (IRR): the interest rate that sets the
present value of a project’s cash inflows equal to the present
value of the project’s cost.
► It is the interest rate that sets the project’s NPV at zero.
► The following equation can be used to determine a project’s IRR,
where t = 1, …, n :

►The right side of this equation is the present value of future

cash flows
►The left side is the investment.
►Thus, the IRR (the interest rate, i, in the equation) can be
found using trial and error.
 Internal Rate of return

The IRR of a project has the following features:

• It represents the discount rate at which the NPV of an investment is zero.

• It can be found by linear interpolation.
• Standard projects (outflow followed by inflows) should be accepted if the IRR is greater than the
firm’s cost of capital.

The IRR provides a decision rule for investment appraisal, but also provides
information about the riskiness of a project – i.e. the sensitivity of its returns.

The project will only continue to have a positive NPV whilst the firm’s cost of
capital is lower than the IRR.
 Internal Rate of return
►The steps in linear interpolation are:
1. Calculate two NPVs for the project at two different costs of capital.
2. Use the following formula to find the IRR
𝑁𝐿
𝐼𝑅𝑅 = 𝐿 + 𝑥 (𝐻 − 𝐿)
𝑁𝐿 −𝑁𝐻
where:
L = Lower rate of interest.
H = Higher rate of interest.
NL = NPV at lower rate of interest.
NH = NPV at higher rate of interest.
3. Compare the IRR with the company’s cost of borrowing.
If the IRR is higher than the cost of capital, the project should be accepted
 Interpretation
of IRR
► A project with a positive NPV at
14% but an IRR of 15% for
example, is clearly sensitive to:
i. an increase in the cost of
finance
ii. an increase in investors’
perception of the potential
risks
iii. any alteration to the estimates
used in the NPV appraisal.
Example
Exercise
The modified IRR
(MIRR)

There are a number of problems with the standard IRR

calculation:

• The assumptions. The IRR only represents the return from the project if
funds can be reinvested at the IRR for the duration of the project
• The decision rule is not always clear cut. If a project has 2 IRRs, it is difficult
to interpret the rule which says, "accept the project if the IRR is higher than
the cost of capital".
• Choosing between projects. Since projects can have multiple IRRs (or none
at all) it is difficult to usefully compare projects using IRR.

It is therefore usually considered more reliable to calculate the

NPV of projects for investment appraisal purposes
 The modified IRR
(MIRR)
▪ MIRR has been developed to counter the
problems of IRR:
▪ It gives a measure of the return from a project
▪ It is therefore more popular with non-
financially minded managers, as a simple rule
can be applied:
▪ MIRR = Project's return
▪ If Project return > company cost of finance =
Accept project
The modified IRR
(MIRR)
► MIRR measures the economic yield of the investment
under the assumption that any cash surpluses are
reinvested at the firm’s current cost of capital.
► MIRR gives a measure of the maximum cost of
finance that allow the project to remain worthwhile.
► For this reason, it gives a useful insight into the room
for negotiation, when considering the financing of
particular investment projects.
 Calculation of MIRR
► There are several ways of calculating the MIRR, but the simplest is to use the
following formula:
1
𝑀𝐼𝑅𝑅 = [𝑃𝑉𝑅ൗ𝑃𝑉𝐼 ]𝑛 𝑥 ( 1 + 𝑟𝑒 − 1
Where,
▪ PVR = the present value of the 'return phase' of the project
▪ PVI = the present value of the 'investment phase' of the project
▪ re = the firm's cost of capital
 Discounted payback period

Payback period measures the length of time it takes for the cash
returns from a project to cover the initial investment.

The main problem with traditional payback period is that it does not
take account of the time value of money

Discounted payback period measures the The shorter the discounted payback period, the
more attractive the project is.
length of time before the discounted cash
returns from a project cover the initial A long-discounted payback period indicates that
the project is a high-risk project
investment.
 Macaulay duration
►Duration measures the average time to recover the present value
of the project (if cash flows are discounted at the cost of capital).
►Duration captures both the time value of money and the whole of
the cash flows of a project.
►Projects with higher durations carry more risk than projects with
lower durations.
►payback, discounted payback and duration are three techniques
that measure the return to liquidity offered by a capital project
 Macaulay duration
►Duration measures: either the average time
► to recover the initial investment (if discounted at the project’s
internal rate of return) of a project, or
► to recover the present value of the project (if discounted at the cost
of capital).
►Duration captures both the time value of money and the
whole of the cash flows of a project.
►It is also a measure which can be used across projects to
indicate when most of the project value will be captured.
Macaulay Duration Formula
Illustration – Macaulay duration
 Test your
Understanding
 Modified
Duration
► Macaulay Duration is the name given to the
weighted average time until cash flows are
received and it is measured in years.
► Modified Duration refers to the price sensitivity
and is the percentage change in price for a unit
change in yield.
► Macaulay Duration and Modified Duration differ
slightly, and there is a simple relationship
between the two (assuming that cash flows are
discounted annually), namely:
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
(1 + 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙)
Capital rationing
► Shareholder wealth is maximised if a
company undertakes all possible positive
NPV projects.
► Capital rationing is where there are
insufficient funds to do so.
► This shortage of funds may be for:
► a single period only – dealt with analysis by
calculating profitability indexes (PIs)
► PI = NPV/PV of capital invested more than one
period
► extending over a number of years or
even indefinitely.
 Profitability Index

Problem: Let us consider a project which is being evaluated by a firm

that has a cost of capital of 12%
Project A Project B
Initial Investment Br 100,000 Br 250,000
net cash flows Year 1 25,000 40,000
Year 2 40,000 80,000
Year 3 40,000 100,000
Year 4 50,000 120,000
[1] Calculate the Profitability Index
[2] which project should be accepted
 Net Present Value Compared with
Internal Rate of Return (continued)

► When choosing between projects, what counts are the total dollars
earned—the absolute profits—not the relative profits.
► Accordingly, NPV, not IRR, should be used for choosing among
competing, mutually exclusive projects or competing projects when
capital funds are limited.
 Net Present Value
for Mutually Exclusive Projects
►There are three steps in selecting the best project
(with the largest NPV) from several competing
projects:
►Step 1: Assess the cash flow pattern for each project.
►Step 2: Compute the NPV for each project.
►Step 3: Identify the project with the greatest NPV.
Mutually exclusive projects: Example
Example; Solution ….
 Test Your
Understanding
 Postaudit of Capital Projects
►A key element in the capital investment
process is a follow-up analysis of a capital
project once it is implemented.
►A post-audit compares the actual benefits with
the estimated benefits and actual operating
costs with estimated operating costs.
►It evaluates the overall outcome of the
investment and proposes corrective action if
needed.
 Postaudit Benefits
►Firms that perform post-audits of capital projects
experience a number of benefits, including the
following:
►Resource Allocation: By evaluating profitability, post-audits
ensure that resources are used wisely.
►Positive Impact on Managers’ Behavior: If managers are
held accountable for the results of a capital investment
decision, they are more likely to make such decisions in the
best interests of the firm.
►Independent Perspective: Post-audit by an independent
party ensures more objective results.
THANK YOU

Tenkir Seifu, PhD

Email: [email protected]

Long term Investment Decisions 2023 56