Capital Investment Decision. Capital Investment Decision. Revision Purpose Methods. The Investment Decision. The objective of the corporation is to Maximise Shareholders Wealth
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The ideal selection method will
Methods for evaluating projects
Figure 6.1 NPV of FFF’s New Project
The graph shows the NPV as a function of the discount rate. The NPV is positive only for discount rates that are less than 14%, the internal rate of return (IRR). Given the cost of capital of 10%, the project has a positive NPV of $100 million.
Why not IRR and does it have a use?
The Bonzo Dog DoDah Band are offered USD2,000,000 today from a rich investor to make a new vinyl LP. They calculate that they will need three years to make the recording and that they will have to give up earnings in each of those years of
USD 1,000,000. Should they do it?
1st question. What is the opportunity cost of capital? Say 6%
2nd question. What is the IRR?
With a wild stabbing guess say 23.38%
+2,000,000 – 1,000,000 – 1,000,000 – 1,000,000
1.2338 (1.2338)2 (1.2338)3
- 1,999,855 = -810,504 - 656,917 - 532,434
That’s close enough
But using 6% as the cost of capital
+ 2,000,000 – 1,000,000 – 1,000,000 -1,000,000
(1.06) (1.06)2 (1.06)3
-2,673,022 = -943,396 - 889,996 - 839,630
So what should they do?
Can we explain what is going on here?
Try working out the NPV for the following
- 1,000,000 + 350,000 +650,000 +650,000 +650,000
and now combine them. What is the combined NPV?
Answer = 787,686 and 855,509 = 1,643,195
As combined flows = 1,643,193
-1,000,000 + 350,000 +650,000 +650,000 +650,000
-1,000,000 + 650,000 +650,000 +650,000 + 350,000
- 2,000,000 + 1,000,000 +1,300,000 + 1,300,000 +1,000,000
- IRR = 43.5%
A return of 50 % or one of 20% ?
an NPV of 50 or an NPV of 500?
Depends for the IRR but you would prefer the higher NPV
Project A with IRR of 12%
-1201 + 500 + 500 + 500
PVF 1.1200 1.2544 1.4049
PV +1201 446 399 356
Double the scale IRR still 12%
-2402 +1000 +1000 +1000
PV +2402 893 797 712
In this case, there is more than one IRR, invalidating the IRR rule. If the opportunity cost of capital is either below 4.723% or above 19.619%, Star should make the investment.
How do we decide when resources are constrained? We need to maximise NPV which may mean not going for the project with the highest NPV, rather the combination of projects that gives the highest total NPV.
Why would resources be constrained?
This could be due to Capital Rationing
150million to invest
Project NPV Investment PI*
A 100 125 .80
B 80 75 1.07
C 70 75 .93
*PI = Profitability Index = Value Created
There are never enough
= Value created = NPV
Resource consumed RC
A mere 200 students are available
380 tonnes of scarce material
Now Moving on
We have to look at all the relevant, incremental cash flows
- Taxes/tax losses
- Opportunity costs
- Working capital
Illustrations using examples from B&DeM
Table 7.1 HomeNet’s Incremental Earnings Forecast (Spreadsheet)
1 Tax losses
3 Interest cost
25 % of the sales of the new product will come from existing sales of a similar product. How do we account for this?
Lost revenue at price of 100 per unit
100,000 x .25 x 100 = 2,500,000
But there will be lower cost of sales
100,000 x .25 x 60 (cost per unit) = 1.5 m
i.e. the effect of the project on the company’s cash.
1. Depreciation (which you are already familiar with
2. Net working capital
Table 7.3 Calculation of HomeNet’s Free Cash Flow (Including Cannibalization and Lost Rent)
Table 7.5 Computing HomeNet’s NPV (Spreadsheet)
- constant growth
1) Year 5 free cash flow is 3,000,000.
If cost of capital is 10% then PV at end year 5 of future cash flows is
3,000,000 = 30,000,000
2) Suppose expect to grow at 3% pa thereafter
Then PV at end year five of future cash flows is
3,000,000 = 42,857,143
.10 - .03
Using the IRR to give a feel for the ‘margin of safety’ ref the cost of capital
Table 7.9 Best- and Worst-Case Parameter Assumptions for HomeNet
Figure 7.1 HomeNet’s NPV Under Best- and Worst-Case Parameter Assumptions
Green bars show the change in NPV under the best-case assumption for each parameter; red bars show the change under the worst-case assumption. Also shown are the break-even levels for each parameter. Under the initial assumptions, HomeNet’s NPV is $5.0 million.
Table 7.10 Scenario Analysis of Alternative Pricing Strategies
The graph shows alternative price per unit and annual volume combinations that lead to an NPV of $5.0 million. Pricing strategies with combinations above this line will lead to a higher NPV and are superior.
Before moving on to other aspects of using the NPV approach we should consider EVA or Economic Value Added.
‘The cash flows of a project less a capital charge that reflects the opportunity cost of the capital invested as well as any capital consumed’
How does it differ from NPV?
Basically NPV gives the return of a project over a period of time while EVA focuses more on the individual time segments within the overall period but will give the same result