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Week 5: Lecture

1
Topic:

Planning Investments

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 2
Investment and the business of the firm
An investment is the outlay of capital made
with a view to gaining future benefits.
Shareholders make an investment when they
purchase the shares of a company and expect
to gain future cash flows in the form of
dividend and/or capital gain when they sell
their investment.
The management of the firm needs to make
investments with the shareholders capital to
generate returns for them.
Therefore, the appraisal of new projects is an
important part of the role of managers.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley.
3
Investment and the business of the firm
Four common characteristics of investment
decisions

1. Relatively large initial outlay.


2. Relatively long horizons.
3. Projects can be difficult to reverse.
4. Projects have risk.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 4
Investment and the business of the firm
1. Relatively large initial outlay some
investment decisions are relatively more
important than others. Before management
makes the investment decision, they should
be in a position to assure themselves that
the expense is justified given the scale of the
firms operation.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 5
Investment and the business of the firm
1. Relatively large initial outlay
The purchase of a single computer in a small
firm rather than a larger bank could be a
relatively large decision. However replacing the
entire computer system in a bank would involve
a larger initial outlay .
Initial outlay the capital expenditure made to
implement an investment.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 6
Investment and the business of the firm
2. Relatively long horizons investment
decisions often cover long periods of time. We
would not expect managers to make a decision
to replace the computer system each year. Even
with rapid technological advances, we would
expect a computer system to last at least five
years.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 7
Investment and the business of the firm
3. Projects can be difficult to reverse
projects once implemented, can be difficult and
expensive to reverse.
Assume our bank installed a new computer
system that was expected to be in service for a
minimum of five years. It could happen that, one
year later, technological advances made the
system obsolete and the new technology
presented significant cost savings over the life of
the system.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 8
Investment and the business of the firm
3. Projects can be difficult to reverse

Management then have two choices: they can


keep the old system for the remaining four years
and then upgrade to the new technology, or they
upgrade now and try to recoup some of the cost
of the old system by selling it.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 9
Investment and the business of the firm
3. Projects can be difficult to reverse
The first option means the bank may lose some
completive edge if all the other banks adopt the
new technology.
The second could mean that the value of the
firm decreases because the cost savings from
operating the new technology might not offset
the losses associated with abandoning the old
system.
What should management do?
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 10
Investment and the business of the firm
4. Projects have risk the longer the
investment horizon, the more uncertain
management will be about what will happen
over the period.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 11
Investment and the business of the firm
Where do project proposals come from?
Investment decisions fall into two main
categories:
i. new projects undertaken to increase cash
flows creating new products or entering
new markets.
ii. replacement of existing assets our
banks decision to install a new computer
system (because it already has a computer
system)
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 12
Investments and the firm value

An important way to add value, or increase


shareholder wealth, is by growth in
operations and the firm needs to make
investments to grow.
Growth can be achieved by expanding the
scale of current operations.
A second way to achieve growth is for the
business to begin new activities.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 13
Investments and the firm value
Appraisal techniques and maximising wealth
Analysis of cash flows rather than profits is
consistent with the objective of maximising
owners wealth.
Hence, the techniques we use should be
based on cash flows rather than profits.
Cash flows represent real resources available
to the firm.
Profit figures are constructed by the
application of accounting rules.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 14
Investments and the firm value
Appraisal techniques and maximising wealth
In addition to using cash flow rather than
profits as the basis for project evaluation, the
chosen technique should consider the time
value of money.
We do not need to allocate a depreciation
expense to our initial outlay because
depreciation is not a cash flow.
The only relevant decrease in the value of
assets of the project is the difference between
the initial outlay and the terminal value.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 15
Investments and the firm value
Appraisal techniques and maximising wealth
Terminal value the expected cash flow
associated with disposal of the project assets
at the end of the projects life.
Our analytical technique needs to have the
capacity to include differences in risks
between competing projects.
The discounted cash flow (DCF) techniques
are consistent with shareholder wealth
maximisation.
Net present value (NPV) and internal rate
or return (IRR) are the two of the most
important DCF techniques.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 16
Estimating cash flows
The most difficult aspect of using the NPV
and IRR techniques is the estimation of
future cash flows for a project.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 17
Estimating cash flows
Identifying relevant cash flows
Marginal analysis is a method for making
decisions to maximise our objective by
comparing additional (marginal) benefits
with additional relevant costs.
The relevant cash flows for investment
evaluation are the marginal ones.
We call these the incremental cash flows
and they result from the acceptance of a
project.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 18
Estimating cash flows
Identifying relevant cash flows
Only incremental cash flows are important
in DCF techniques, total cash flows are
irrelevant.
If a cash flow will occur with or without the
new project, it is not incremental and it is
irrelevant to the investment decision.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 19
Asking the Right Question
You should always ask yourself Will this cash flow
occur ONLY if we accept the project?
If the answer is yes, it should be included in
the analysis because it is incremental
If the answer is no, it should not be included in
the analysis because it will occur anyway
If the answer is part of it, then we should
include the part that occurs because of the
project
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 20
Estimating cash flows

Identifying relevant cash flows


If the cash flow exists only when the new
project is adopted, it is an incremental cash
flow.
Operating costs are the cash outflows
required in the daily activities of the project.
Opportunity costs are the cash flows
forgone when one path of action is chosen.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 21
Estimating cash flows

Identifying relevant cash flows


Sunk costs are cash outflows that occur
prior to the evaluation of a project.
Sunk costs are not relevant cash flows and
therefore should not be included when
applying DCF analysis as they are not
incremental.
The cost of finance for the project should not
be included in the projects cash flows.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 22
Estimating cash flows
Identifying relevant cash flows
The cash flows of a proposed project with
the same level of risk as the firms existing
projects are discounted using the firms cost
of capital.
Discounting at the cost of capital means we
are already charging the project for its
financing costs. Including dividends and
interest payments as cash outflows of the
project would mean double counting the
cost of finance.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 23
Estimating cash flows

Cash flows are grouped into three areas of


analysis:

1. Initial outlay
2. Net operating cash flows
3. Terminal value.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 24
Estimating cash flows
Estimating the initial outlay
The initial outlay of the project is often the
cash flow that can be identified with the
highest degree of certainty.
The installed cost includes the purchase
price of the equipment, delivery charges and
any installation cost.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 25
Estimating cash flows
Example
Consider a firm that manufactures clothes
washing products. Clean O Ltd has a number
of products that have been especially designed
for normal washing, for washing wool and
delicate fabrics and one for those hard-to-shift
satins. The managers have before them a
proposal to develop a new product, called
Greenwash, which contains lower level of
phosphates.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 26
Estimating cash flows
Example contd
Assume Clean O will install a new production
line for the specific purpose of manufacturing
Greenwash. The purchase price of the machine
is $1 million. Shipping and road transport costs
are expected to be $150 000. there is enough
space in Clean Os existing factory and this
space does not currently have any cash-
generating potential. The company has
obtained a quote of $10 000 from an electrician
willing to do installation when Clean O wants
it to be done. What is the installed cost for the
Greenwash project?
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 27
Estimating cash flows
Example contd

Installed cost of new asset:


Purchase Price 1 000 000

Transport Cost 150 000

Electrician 10 000

1 160 000

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 28
Estimating cash flows
Estimating the initial outlay

Changes in net working capital are also


included in the initial outlay.
Net working capital is the excess of current
assets over current liabilities.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 29
Estimating cash flows
Example
Greenwash project would require an additional
$10000 in raw material. Finished goods
inventories would increase by $30 000. The
accounting department has estimated an
increase of $40 000 in accounts receivable from
the sales of Greenwash made on credit. Suppliers
of Clean Os raw material offer the firm credit
and accounts payable would increase by $10 000.
What change in net working capital should be
included in the initial outlay of Greenwash
project?
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 30
Estimating cash flows
Example contd

Change in net working capital:


Add increase in raw materials 10 000

Add increase in finished goods 30 000

Add increase in accounts receivable 40 000

Less increase in accounts payable (10 000)

70 000

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 31
Estimating cash flows
Estimating the initial outlay

Outlays for any special training staff needed


to operate the project should be included in
the initial outlay of an expansion project.
The costs of hiring new staff who will work
on the project specifically should also be
included.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 32
Estimating cash flows
Example
The new production line for Greenwash is
computerized and two current production
employees will be trained by the manufacturer of
the new equipment for a total cost of $2 000. The
marketing department wants to spend $100,000
per annum on advertising, with one-off
campaign costing $50 000 at the start of the
project. Using the installed cost calculated in the
previous example and the change in net working
capital, determine the initial outlay.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 33
Estimating cash flows
Example contd

Initial outlay:
Installed cost of new asset 1 160 000

Add increase in working capital 70 000

Add training costs 2 000

Add initial advertising cost 50 000

1 282 000

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 34
Estimating cash flows
Estimating the initial outlay
Determining the initial outlay for a
replacement decision requires one
additional element to be included.
The cash flows from an asset that is being
replaced will usually decrease, but can
sometimes increase, the installed cost for a
replacement decision.
The asset being replaced may still have a
value in either the second-hand or scrap
markets.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 35
Estimating cash flows
Estimating the initial outlay
Here the net cash flows from the sale of the
existing asset are included as reductions in
the initial outlay of the new machine.
Sometimes there is a net cash outflow from
the old asset. This can occur if the firm has
to pay to have the asset dismantled and
removed.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 36
Estimating cash flows
Estimating the initial outlay
Also the cost of cleaning up any
environmental damage that the asset has
caused has to be considered.
We include the cash inflows and outflows
from the disposal of the existing assets in the
initial outlay of the replacement decisions
because they are incremental. They would
not be generated unless the new project was
accepted.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 37
Estimating cash flows
Example
After investigating new production facilities for
the Greenwash project, Clean O are considering
replacing the existing production line they use
for manufacturing their other products. The
purchase price, transport costs and electrical are
$1 million, $150 000 and $10 000 respectively. The
new production line will occupy the space of the
current machinery. The old machinery would sell
for $50 000. it would cost around $1500 to
dismantle the machine in preparation for sale.
What is the installed cost for the replacement
project?
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 38
Estimating cash flows
Example contd
Cash outflows for replacement machine

Purchase price 1 000 000

Transport cost 150 000

Electrician 10 000

1 160 000

Cash inflow from existing machine

Sale of machine 50 000

Cash outflow from existing machine

Dismantling cost 1 500

1 111 500

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 39
Estimating cash flows
Estimating the initial outlay

A project to adopt new technologies to save


costs should be classified as a replacement
decision where existing technology is being
exchanged for the new technology as seen in
the example.
At other times, new technology is adopted to
run parallel to the existing assets of the firm.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 40
Estimating cash flows
Estimating the net operating cash flows
The most important thing to remember
when constructing a series of operating
cash flows is to look at the incremental
cash flows.
If inflows will be diverted from other areas of
the firm, these lost cash flows should be
deducted from those of the new project.
If there are incidental increases in cash flows
to other areas of the firm from the new
project, then these should be added to the
cash flows for the analysis of the new project.
Similarly, costs should also be incremental
only to the new project.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 41
Estimating cash flows
Example
The management of Clean O have assembled the
following annual forecasts of the operating cash
flows for Greenwash
Sales of Greenwash for the first year: $1 000 000
Sales are expected to grow at a rate of 5% for
years 2 and 3, then decline by 5% pa in years 4
and 5
Sales diverted from existing Clean O products:
$100 000
Raw materials will be 24% of sales

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 42
Estimating cash flows
Example contd

Labour: $90 000


Electricity: $7 000
Advertising cost for years 1 to 4 : $100 000
These forecasts are best available estimates for
each year, ending in 5 years time. What is the net
annual operating cash flow for Greenwash
project?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 43
Estimating cash flows
Example
Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

Sales of Greenwash 1 000 000 1 050 000 1 102 500 1 047 375 995 006

Lost sales -100 000 -100 000 -100 000 -100 000 -100 000

Raw materials -240 000 -252 000 -264 600 -251 370 -238 801

Labour -90 000 -90 000 -90 000 -90 000 -90 000

Electricity -7 000 -7 000 -7 000 -7 000 -7 000

Advertising -100 000 -100 000 -100 000 -100 000

Net operating cash 463 000 501 000 540 900 499 005 559205
flow

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 44
Estimating cash flows
Estimating the terminal value
The terminal value of a project is the cash
inflow or outflow that is expected at the end
of the projects life.
It is a relevant cash flow because it will not
exist unless the project is accepted.
The main sources of terminal cash flows are
the salvage value of any assets used by the
project and the return of net working capital.
Net working capital is not used up in
production process because it is constantly
replaced over the life of the project.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 45
Estimating cash flows

Example

The Greenwash project is expected to continue


for 5 years. At the end of that time, management
expect to sell the production line that was
purchased for the project for $400 000. The
estimated cost of dismantling the production line
is $4000. What is the terminal value of the
project?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 46
Estimating cash flows
Example contd

Cash flow at project termination


Sale of machine 400 000

Less dismantling cost 4 000

Cash inflow from machine 396 000

Add return of net working capital 70 000

Terminal value 466 000

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 47
Estimating cash flows
Identifying annual cash flows

We organize each of the cash flow components in


sequence so we can properly adjust for the time value
of the cash flows.
Time zero is when the initial outlay of the project is
made.
When measuring cash flows on an annual basis, the
first operating cash flows occur at the end of the first
year.
The terminal value is usually included in the final
years cash flow.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 48
Estimating cash flows
Identifying annual cash flows
Annual cash flows for the Green wash project
Time Zero Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

Initial outlay -1 282 000

Net operating 463 000 501 000 540 900 499 005 559205
cash flow
Terminal 466 000
value
Net cash -1 282 000 463 000 501 000 540 900 499 005 1 025 205
flows

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 49
Estimating cash flows

Once we have assembled our cash flows, we are


ready to apply our discounted cash flow
techniques.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 50
Net present value
The net present value (NPV) of a proposed project is the
sum of the discounted net cash flows over the life of a
project, minus the projects initial outlay.
We can calculate the NPV of a project by applying
the following equation to the project cash flows.

Accept a project if NPV >= 0


Reject a project if NPV < 0
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 51
Net present value
Calculating the NPV of the Greenwash project assuming
cost of capital for Clean O of 10%
Time Zero Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Initial outlay -1 282 000
Net operating 463 000 501 000 540 900 499 005 559205
cash flow
Terminal 466 000
value
Net cash -1 282 000 463 000 501 000 540 900 499 005 1 025 205
flows
Discount 1 (1+0.10)-1 (1+0.10)-2 (1+0.10)-3 (1+0.10)-4 (1+0.10)-5
factor 0.9091 0.8264 0.7513 0.6830 0.6209
Present value -1 282 000 420 913 414 026 406 378 340 820 636 550
NPV 936 687

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 52
Internal rate of return
The internal rate of return (IRR) is the
discount rate that equates the present value of the
projects cash flows to the initial outlay of the
project.
Therefore, the IRR tells us the rate of return
that the project is expected to earn.
We apply the following equation to the
projects cash flows to determine the IRR.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 53
Internal rate of return
The decision rule to use with the IRR
technique is to compare the projects IRR to
the hurdle rate:
Accept a proposed project if IRR >= hurdle rate
Reject a proposed project if IRR <= hurdle rate
The hurdle rate is the minimum rate of
return generated that will make a project
acceptable.
The cost of capital is the appropriate hurdle
rate for the IRR technique when the project
risk is the same as that of current projects.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 54
Internal rate of return
Calculating the IRR of the Greenwash project

Try 31% as a first pass at the cost of debt


NPV = 463000/(1.31)+501000/(1.31)2 + 540900/(1.31)3
499005/(1.31)4 + 1025205/(1.31)5 = 1,321,160.11
Try 32%
NPV = 463000/(1.32)+501000/(1.32)2 + 540900/(1.32)3
499005/(1.32)4 + 1025205/(1.32)5 = 1,293,658
Try 33%
NPV = 463000/(1.33)+501000/(1.33)2 + 540900/(1.33)3
499005/(1.33)4 + 1025205/(1.33)5 = 1,267,086.46

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 55
Internal rate of return
So we take the interpolation between 32% and 33%
as:
Difference of lower discount rate value and initial
cost 1,293,658 1,282,000 = 11,658
Difference of lower and higher discount rate value
1,293,658 1,267,086.46= 26,571.54
Take ratio of difference 11,658/26,571.54 = 0.44
Lower rate ratio 32% +0.44 = 32.44%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 56
Analysing a set of projects
Capital constraints
Capital rationing is a self-imposed limit that
is placed on the size of the capital budget.
When the amount of money available for
investment projects is unlimited, all positive
NPV projects or all projects with IRRs greater
than the hurdle rate should be accepted to
maximise firm value.
When the firm imposes a capital constraint,
our decision rules have to be adapted to
maximise firm value given the size of the
capital budget.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 57
Analysing a set of projects
Capital constraints

The NPV rules are adapted under capital


rationing so that the set of projects that gives
the highest total NPV and remains within the
capital budget constraint is chosen.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 58
Analysing a set of projects
Mutually exclusive projects
Mutually exclusive projects either perform
the same task or utilise the same scarce
physical resources. Acceptance of one project
means that the others must be rejected.
Mutual exclusivity does not present a problem
for project selection if the initial outlays of
the projects are the same size, the cash
flow patterns are similar and the projects
have the same life span.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 59
Analysing a set of projects
Mutually exclusive projects
The size disparity
When mutually exclusive projects have
different initial outlays we need to take this
size disparity into consideration.
We should use the NPV method to rank
projects rather than the IRR method when this
problem arises.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 60
Analysing a set of projects
Mutually exclusive projects - The size disparity
Example (assuming discount rate of 10%)
Project A Project B
Time zero Year 1 Time zero Year 1
IO -10 000 -50 000
Cash Flow 15 000 60 000
Discount factor 1 0.9091 1 0.9091
PV -10 000 13 636 -50 000 54 546
NPV 3637 4546
IRR 50% 20%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 61
Analysing a set of projects
Mutually exclusive projects
Cash flow timing disparity
A second complication for mutually exclusive
projects occurs when the projects have very
different cash flow patterns over their lives,
even when the initial outlay is identical.
This disparity in the timing of cash flows
causes different rankings under the NPV and
IRR techniques.
Again, the NPV technique is recommended to
overcome the timing disparity problem.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 62
Analysing a set of projects
Mutually exclusive projects - Cash flow timing disparity
Example (assuming discount rate of 10%)
Project A Project B
Time Year 1 Year 2 Year 3 Time Year 1 Year 2 Year 3
zero zero
IO -50000 -50000
Cash 25000 25000 25000 5000 5000 75000
Flow
Discount 1 0.9091 0.8264 0.7513 1 0.9091 0.8264 0.7513
factor
PV -50000 22728 20660 18783 -50 000 4546 4132 56348

NPV 12171 15026


IRR 23% 21%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 63
Analysing a set of projects
Mutually exclusive projects - Unequal lives
The final source of ranking differences results
when projects have different lives. Mutually
exclusive projects with different lives are not
directly comparable.
An equivalent annual annuity (EAA) is the
equal annual cash flows that would generate
the projects NPV during the projects life.
The EAA method annualizes the cash flows
over the life of each project to make them
comparable.
We need to calculate the NPV for the life of
each project before we can calculate the EAAs.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 64
Analysing a set of projects
Mutually exclusive projects -Unequal lives
We then divide the NPV by the present value
interest factor of an annuity that corresponds
to the discount rate and the number of years
that the project runs.

The decision rule is to select the project with


the highest EAA.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 65
Analysing a set of projects
Mutually exclusive projects -Unequal lives
Example(assuming discount rate of 10%)
Project A Project B
Time Year 1 Year 2 Time Year 1 Year 2 Year 3 Year 4
zero zero
IO -50000 -50000

Cash 40000 40000 30000 30000 30000 30000


Flow
Discount 1 0.9091 0.8264 1 0.9091 0.8264 0.7513 0.683
factor 0
PV -50000 36364 33056 -50 000 27273 24792 22539 20490

NPV 19420 45094


IRR 38% 47%
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 66
Analysing a set of projects
Mutually exclusive projects -Unequal lives
Example contd : calculating EAA

EAA for project A


EAA = 19420/1.7355
= 11190
EAA for project B
EAA = 45094/3.1699
= 14226
Accepting project A is equivalent to receiving
$11190 per annum whereas accepting Project B is
equivalent to receiving $14226 per annum
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 67
Non-financial factors in project choices

Around 75% of decision makers from the


largest Australian organisations reported that
they had accepted projects that failed to pass
the quantitative hurdles.
This means that decision makers are using
qualitative criteria to override the outcome
suggested by quantitative analysis.
The main reason for adopting quantitatively
unacceptable projects is that they have
strategic value for the firm.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 68
Non-financial factors in project choices

Giving consideration to non-financial factors


such as the environment, workplace practices
and corporate governance is not only socially
responsible it also benefits the firm by
reducing the level of non-financial risk.
Of course, not everyone agrees, and some argue
that the role of business is to generate wealth
and create jobs without being overly concerned
about factors outside the legal requirements
that must be met by companies.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 69
Non-financial factors in project choices

Ethical or socially responsible investing has


been an increasing phenomenon around the
world.

There is no standard way to incorporate


qualitative factors into project evaluation the
weighting given to these factors will vary on a
case-to-case basis.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 9, Australia: Wiley. 70
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