L5 Investment decisions and project

analysis (Chapter 8,9,10)

Payback, NPV, PI, IRR

Estimating cash flows
Break-even analysis
 Capital Budgeting decision
Capital Budgeting: The process of planning long-term investment,
e.g. purchases of long-term assets.
• Criteria take into account
– Timing: Various points in time during its economic life (n)

Initial
outlay Annual Cash Flows

0 1 2 3 4 5 6 ... n
– Cash flows
• Costs: cash outflow or investment outlay, which occurs generally at
time 0 (today),
• Benefits: cash inflows
 Payback Period
• The amount of time required for an investment to
generate sufficient cash flows to recover its initial
cost.
• Payback Period = number of years to recover initial
costs.

• Payback period=2
 Decision rule based on Payback
Period
• Payback Period is less
than benchmark Accept

• Payback Period is
greater than Reject
benchmark
 Payback Period, another example
Time Period 0 1 2 3
Project 1 - €25 15 8 10

€15 + €8 = € 23 < € 25
Payback period is more than 2 years

€ 25 – € 23 = € 2 will be recovered in the third year

Assuming that cash inflow is constant and steady throughout a year;
[2 years + (€ 2/€ 10) = 2.2 years]
The length of time to recover €2 in the third year.
 Payback Period
• Advantages:
– Easy to understand.
– Focuses on liquidity, which will be important with
high uncertain economic conditions.
• Drawbacks:
– Firm cutoffs (minimum acceptance criteria) are
subjective.
– Does not consider the cash flow beyond cut-off date.
– Does not consider time value of money.
– Does not consider any required rate of return
(discount rate).
• Discounted payback period solves last two problems.
 Discounted Payback Period

Time Period 0 1 2 3
Project 2 -€5 2.5 2.5 2.5
€2.5 € 2.5
PV of year 1 CF = = 2.23 PV of year 2 CF = = 1.99
(1 + 0.12) (1+0.12)2

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑃𝑃𝑃𝑃 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 1 𝑎𝑎𝑎𝑎𝑎𝑎 2 = 2.23 + 1.99 = 4.23

Amount of intial outlay not yet recovered by year 1 and 2 CF = 5 − 4.23 = 0.77

€2.5
PV of year 3 CF = 3
= 1.78
(1 + 0.12)

Payback period is more than 2 years, i.e.

[2 years +(€ 0.77/€ 1.78)]=2.43 years
 Other Criteria
2) Net Present Value (NPV)
3) Profitability Index (PI)
4) Internal Rate of Return (IRR)

All criteria:
• Considers the time value of money,
• Considers the required rate of return, and
• Examines all net cash flows.
 Net Present Value
• NPV = Total PV of the annual net cash flows – cost
investment’s market value

CF: Annual Cash Flows

n: Economic Life
CF0: Initial Cost or Investment
r: Discount rate (Project’s required rate of return,
Weighted Average Cost of Capital/WACC)
 Net Present Value (NPV)
An example

Time Period 0 1 2 3
Project -€5 2.5 2.5 2.5

r : discount rate (required rate of return) : 12%

€2.5 €2.5 €2.5
𝑁𝑁𝑁𝑁𝑁𝑁 = + 2
+ 3
−5
(1 + 0.12) (1 + 0.12) (1 + 0.12)
= 1.005
 Profitability Index
Very similar to Net Present Value.
Instead of Subtracting the Initial Outlay from the PV of Inflows, the
Profitability Index is the ratio of the PV of Inflows to Initial Outlay,
so measures the value created per cash unit invested.

n
Σ
CFt
PI = (1 + r)t CF0
t=1

PI = 6.005/5=1.201

Accept if PI > 1

Select alternative with highest PI (PI2 > PI1)

 Internal Rate of Return (IRR)
• IRR: the discount rate that makes NPV zero.

• Internal Rate of Return is greater

than the required rate (or discount
rate) Accept
Reject
• Internal Rate of Return is less than
the required rate (or discount rate)
Figure 8.5 An investment costs €100 and has a cash flow of €60
per year for two years. What is its Internal Rate of Return?
Advantages and Disadvantages of
IRR
 Mutually Exclusive Investments

The IRR for A is 24 per cent, and the IRR for B is 21 per cent.
Because these investments are mutually exclusive, we can take
only one of them. Simple intuition suggests that investment A
is better because of its higher return. Unfortunately, simple
intuition is not always correct.
Mutually Exclusive Investments
 Which method is the best?
• NPV
– reflects the stated objective of the firm,
– investment with NPV > 0 will increase the firm value,
– increasing in shareholder wealth.

• Advantages of IRR:
– Easy to understand and communicate.
• Doesn’t use r, (discount rate, or hurdle rate, or WACC) (really?)
• Provide an answer as rate of return.

• Disadvantages of IRR:
– IRR may not exist or there may be multiple IRR.
– Scale Problem:
• Would you rather make 100% or 50% on your investments?
• What if the 100% return is on a €1 investment while the 50% return is
on a €1,000 investment?
• Conclusion: NPV is the best method 17
 Why so many alternatives?
• Because of uncertainty, NPV can only be
estimated, such as CF, required return
• Alternatives provide 2nd opinion on
assessment
– Consistent conclusion, go for it
– Conflicting signals, be alert, further analysis

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The Practice of Capital Budgeting
Chapter 9
Estimate cash flows

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 An essential input for investment decision
• Need to estimate cash flows

• Cash flow is the king, because a firm can spend its

operating cash flow but not its net income.
• Incremental Cash Flow is defined as
– The difference between a firm’s future cash flows with
a project and those without the project.
– any and all changes in the firm’s future cash flows that
are a direct consequence of taking the project.
• Question: Are they incremental cash flows: sunk
cost, opportunity cost, cost caused by side effect?
– Check page 221
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Consideration of some types of cash
flows Do not
Sunk Cost include!
• A cost that has already been incurred and cannot be removed.
• R&D expenses, fees for financial consultants, etc.
Include!
Opportunity Cost
• The most valuable alternative that is given up if a particular
investment is undertaken.
• Use of already owned assets.
Include!
Cost caused by side Effects
• The cash flows of a new project that come at the expense of a
firm’s existing projects.
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 Incremental Cash Flow
“The difference between a firm’s future cash flows
with a project and those without the project.”
Follow 3 steps:
a. Initial capital investment (capital spending)
b. Annual Operating Cash Flows over the life of the
project (annual cash flows).
c. Terminal Year Cash Flows
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a. Determination of capital spending

Total Capital Spending

= Investment in fixed assets
+ Initial Increase in Net Working Capital (NWC)

Notes on NWC (= current assets – current liabilities)

• changes in current assets such as inventory and receivables
and current liabilities such as accounts payables.
• at the end of the project, these additional cash flows are
recovered and must be accordingly shown as cash inflows
at the terminal year

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 EXAMPLE
• We think we can sell 50,000 cans of shark attractant per year at a
price of £4 per can. It costs us about £2.50 per can to make the
attractant, and a new product such as this one typically has only a
three-year life. We require a 20 per cent return on new products.
• Fixed costs for the project, including such things as rent on the
production facility, will run £12,000 per year.
• Further, we will need to invest a total of £90,000 in manufacturing
equipment.
• We will assume that this £90,000 will be 100 per cent depreciated
straight line over the three-year life of the project. Furthermore, the
cost of removing the equipment will roughly equal its actual value in
three years, so it will be essentially worthless on a market value basis
as well.
• Finally, the project will require an initial £20,000 investment in net
working capital, and the tax rate is 34 per cent.
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 Example capital spending

a) Capital Spending: What is the cash flow at “time 0?”

£ 90,000 (CAPEX: Capital expenditure)

20,000 net working capital
£110,000
CF0= £ -110,000

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 b. Estimation of the annual operating cash flows
Annual Operating Cash Flows (incremental):
A firm can spend its operating cash flow but not its net income.
OCF = Net Income + Depreciation

• Depreciation is not a cash expense because no money leaves the

firm, however; it reduces taxes and increases cash flows.
• Straight-line depreciation: The annual depreciation expenses are
the same for each year.
Initial Cost - Expected Residual Value
Annual Depreciation =
Economic Life
An alternative way to get OCF
OCF = (Sales-costs)*(1-T) + Depreciation tax shield
Depreciation tax shield= Depreciation *tax rate
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 Table 9.1: Projected Income Statement

200,000 Sales (50,000 units at 4 £/unit)

-125,000 Variable Cost (2.50 £/unit )
75,000 Gross Profit
-12,000 Fixed costs
-30,000 Depreciation Straight line: (90,000/3)

33,000 Earnings before interest & taxes (EBIT)

-11,220 Taxes (34%)
21,780 Net Income

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 Years 1 to 3: Annual Operating Cash Flows
21,780 Net Income
+30,000 Add back Depreciation
51,780 Operating cash flows
Alternative approach for OCF
200,000 Sales (50,000 units at 4 £/unit)
-125,000 Variable Cost (2.50 £/unit )
-12,000 Fixed costs
63,000 Gross profits before tax
-21,420 Taxes (34%)
41,580 = (Sales-costs)*(1-Tax rate)
+10,200 Tax shield (30,000*34%)
51,780 Operating cash flow 29
c. Estimation of terminal year cash flow
• The terminal year: last year of the economic life.
• Terminal Year Cash flow =
Annual OCF
+ Recovery of Net Working Capital Investment
+ After tax Salvage Value (Sale of the equipment)

51,780 Annual OCF

20,000 Recover of NWC
0 Salvage value
71,780 Terminal year Cash Flow

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Project Operating Cash Flow
Whenever we have an inv. in
NWC, the same inv has to be
recovered at the end when
project is finished

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 Project NPV

NPV = −£110,000 + 51,780/1.2 +

51,780/1.22 + 71,780/1.23
= £10,648

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 Chapter 10
Project analysis: what-if analysis,
with a focus on break-even
analysis

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 Break-Even Analysis
Sales volume of a project is important but difficult
to estimate. Break-even analysis is to examine the
relationship between sales and profitability.
Accounting Break-Even
• The sales level that results in zero project net
income.
Cash Break-Even
• The sales level that results in a zero OCF.
Financial Break-Even
• The sales level that results in a zero NPV. 34
 Differentiate: Total Costs, fixed
costs and variables cost
Total variable cost = Total quantity of output × Cost per unit
of output
VC = Q × v

Total costs (TC) for a given level of output are the sum of
variable costs (VC) and fixed costs (FC):

TC = VC + FC = v × Q + FC
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Total, Fixed and Variable Costs

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 Accounting Break-Even
• Project net income is given by:
Net income = (Sales − Variable costs − Fixed cost
− Depreciation) × (1 − T)
= (S − VC − FC − D) × (1 − T)
• If we set this net income equal to zero, we get:
S − VC − FC − D = 0
• Because S = P × Q and VC = v × Q, then we can
rearrange the equation to solve for the
accounting breakeven level:
Q= (FC+D)/(P-v)
 Cash Break-Even
• The relationship between operating cash flow and sales
volume (ignoring taxes, tax rate=0) is:
Operating cash flow = Net income + Depreciation
= (S − VC − FC − D) × (1-T) + D
OCF = [(P − v) × Q − FC − D] + D = (P − v) × Q − FC
• Rearrange, we get:
Q = (FC + OCF)/(P − v)
• This tells us what sales volume (Q) is necessary to achieve any
given OCF.
• To calculate the cash break-even (the point where operating
cash flow is equal to zero), we put in a zero for OCF:
Q = FC /(P − v)

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 Financial Break-Even
• Financial Break-Even point is the sales level that results in
a zero NPV.
• Operating cash flow = Net income + Depreciation (tax rate
is assumed 0)
OCF* = (S − VC − FC − D) + D
= (P − v) × Q − FC
• Rearrange, we get financial break-even
Q = (FC + OCF*)/(P − v)
here OCF* is operating cash flow that makes NPV zero.

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Tutorial 5: Guest talk + Ch 8,9,10
Guest talk from Philips on capital
budgeting decision
Ch 8
• A question on multiple investment criteria
Ch 9
• 9.1, 9.2, a question on OCF and NPV
Ch 10
• 10.10
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