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INVESTING WITH TALENT

Original written by Professor Javier Vega Fernández at IE Business School.
Original version, April 19, 2001. Last revised February 06, 2018 (LR).
Published by IE Publishing. María de Molina 13, 28006 – Madrid, Spain.
©2001 IE. Total or partial publication of this document without the express, written consent of IE is prohibited.

INTRODUCTION

The word talent—a special aptitude or faculty, or high mental ability—has a curious etymological
origin. It comes from the parable of the talents, which according to the Gospel of Saint Matthew, is
as follows:

A man traveling into a far country ... called his own servants, and delivered unto them
his goods. And unto one he gave five talents 1, to another two, and to another one; to
every man according to his several ability 2; and straightway took his journey. Then
he that had received the five talents went and traded with the same, and made them
other five talents. And likewise he that had received two, he also gained other two.
But he that had received one went and digged in the earth, and hid his lord's money.
After a long time the lord of those servants cometh, and reckoneth with them. And so
he that had received five talents came and brought other five talents, saying, Lord,
thou deliveredst unto me five talents: behold, I have gained beside them five talents
more. His lord said unto him, Well done, thou good and faithful servant: thou hast
been faithful over a few things, I will make thee ruler over many things: enter thou
into the joy of thy lord. He also that had received two talents came and said, Lord,
thou deliveredst unto me two talents: behold, I have gained two other talents beside
them. His lord said unto him, Well done, good and faithful servant; thou hast been
faithful over a few things, I will make thee ruler over many things: enter thou into the
joy of thy lord. Then he which had received the one talent came and said, Lord, I
knew thee that thou art an hard man, reaping where thou hast not sown, and
gathering where thou hast not strawed: And I was afraid, and went and hid thy talent
in the earth: lo, there thou hast that is thine. His lord answered and said unto him,
Thou wicked and slothful servant, thou knewest that I reap where I sowed not, and
gather where I have not strawed: Thou oughtest therefore to have put my money to
the exchangers, and then at my coming I should have received mine own with usury.
Take therefore the talent from him, and give it unto him which hath ten talents. For
unto every one that hath shall be given, and he shall have abundance: but from him
that hath not shall be taken away even that which he hath. And cast ye the
unprofitable servant into outer darkness: there shall be weeping and gnashing of
teeth.”
Matthew 25:14-30

1
A talent was not a coin but rather a unit of account used by the Greeks and Romans. In the case of a gold talent, it was
a considerable amount at the time, worth approximately 30,000 euros in year 2000 prices.
2
Hence, “to each according to his ability,” which is where the modern sense of talent comes from.

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This example of wisdom—for Christians the word of God—has the virtue of timelessness. Two
thousand years on, its arguments are still valid as far as their moral content is concerned, and they
serve as a guide to those who are or wish to become professional managers of businesses.

If we translate the protagonists of the parable in time, we could say that the man who goes away
represents the shareholders; the servants, the managers; the enjoyment of the lord represents all
types of self-improvement in one’s career (“thou hast been faithful over a few things, I will make thee
ruler over many things”); and the gnashing of teeth is equivalent to on-the-spot dismissal.

From this point of view, being a professional manager implies taking charge of investors’ money with
the purpose of returning it to them with interest in the future. The shortcoming of this simple definition
of what has come to be known as the “financial function of the company” is that it is imprecise. How
much richer do we have to make investors in order for them to be content? Since 1950, financial
theoreticians have tried to establish appropriate procedures to allow them to answer this question.
This chapter is devoted to describing them and to judging, with reasons, when it is appropriate to use
them.

I.- THE FINANCE DIRECTOR AT THE CROSSROADS

Let us suppose that a group of investors charges us with the task of administering part of their
fortune—let us say €100 million—in exchange for a satisfactory salary. Well, to be honest, a highly
satisfactory salary. Suddenly we find ourselves sat on a considerable pile of money without really
knowing what to do with it. The first temptation would be to safeguard (bury) our benefactors’ money,
but when we recall the parable of the talents we realize that this approach is not really advisable.

We have a second alternative. Pay the money into the bank and receive interest on it at market rates.
Let us suppose the interest rate is currently 5%. Our instinct should warn us that this is a sterile
option. Do our investors really need your services in order to put the money on deposit in the bank?
Does this “work” merit the salary they are paying us? Generally speaking, investors do not usually
hire people to do something they could do for themselves at no cost or effort.

This train of thought leads us to another doubt: how much money should we earn with the investors’
hundred million euros in order for them to feel satisfied with our management? The best way of
resolving this question, for the time being, is to ask the owners of the money themselves. Let us
suppose that they reply that the return they are getting on other businesses is 10%. We know then,
that we cannot invest the money in anything that yields less than this reference rate of 10%.
Therefore, we did the right thing not to deposit the money in the bank at a rate of 5%. If we had done
so, we would have found that in a year’s time the bank would have given us back €105 million, i.e.,
€100m x (1+0.05), when the shareholders were confidently expecting €110 million; €100m x(1+0.10).

In chapter I, we learned how to calculate the present value of assets on the basis of a reference
interest rate and the income stream the asset is expected to produce in the future. We can also use
this procedure to evaluate the two alternatives that we have on the table: keeping the money in the
safe or depositing it at the bank at 5%. The results would be as follows:

100
VASafe = = 90.9
1. 1

105
VABank = = 95.45
1 .1

Let us interpret the values we have obtained. If we insist on keeping the money in cash locked in the
safe for a year, our investors will perceive—today—that the value of their money has dropped

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to 90.9 million euros. Why? Because nobody who wants to earn 10% and is able to do so would
pay more than €90.9 million today for €100 million a year from now, as invested at 10% €90.9
million would become €100 million in a year: €90.9m x (1+0.1) = €100m.

Alternatively, if we decided to put the money in the bank and the bank paid 5% interest, thereby
converting the sum into €105 million in a year’s time, our investors would value their money at €95.45
million. Because nobody who can earn ten percent in an alternative business would be willing to pay
more than this amount which, invested today at 10%, would become €95.45m x (1+0.01) = €105
million in a year’s time.

Therefore, if we want to keep our job, we need to find a business opportunity that gives a return of
at least €10 million at the end of the year, as otherwise, our investors would be less well off than they
were before they hired us, which demonstrates that they do not really need us at all. This briefly
describes what we could call the danger of being a financial director without talent.

II.- THE BASICS OF INVESTMENT ANALYSIS

The example used so far had a time horizon of a year. Let us extend it now to a longer period, for
example, five years. Let us suppose that we are offered the possibility of investing 100 million euros
in return for the five alternative income streams shown in table 1.

TABLE 1

1 2 3 4 5

Alternative 1 7 7 7 7 107
Alternative 2 9 9 9 9 109
Alternative 3 10 10 10 10 110
Alternative 4 12 12 12 12 112
Alternative 5 15 15 15 15 115

The present values of the five alternatives, based on a reference interest rate of 10%, are as follows:
What this tells us is that if we choose alternatives 1 or 2, our decision will make our investors poorer

7 7 7 7 107
PV1 = + 2
+ 3
+ 4
+ = 88.63
(1.1) (1.1) (1.1) (1.1) (1.1) 5

9 9 9 9 109
PV2 = + 2
+ 3
+ 4
+ = 96.21
(1.1) (1.1) (1.1) (1.1) (1.1) 5

10 10 10 10 110
PV3 = + 2
+ 3
+ 4
+ = 100
(1.1) (1.1) (1.1) (1.1) (1.1) 5

12 12 12 12 112
PV4 = + 2
+ 3
+ 4
+ = 107.58
(1.1) (1.1) (1.1) (1.1) (1.1) 5

15 15 15 15 115
PV5 = + 2
+ 3
+ 4
+ = 118.95
(1.1) (1.1) (1.1) (1.1) (1.1) 5
than they are at the moment; if we choose option 3, their wealth will remain unchanged; and if we

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opt for alternatives 4 and 5, we would make them richer than they are at the moment. There is no
doubt that our shareholders would be delighted if we invested their money in alternative 5, because
their wealth would increase instantly by €18.95 million (€118.95m – €100m).

Let us look at this point in a little more detail. What does it mean to say that the investors are instantly
better off? If the investors had invested their hundred million euros in businesses they are already
familiar with, without our involvement, in five years they would obtain €100m x (1 + 0.01) 5 =
€161.05m. However, if they entrust their money to us and we invest it in alternative 5, they will obtain
a series of annual income payments which they can, in turn, invest in those businesses 3. The result
of this operation would be:

FV = 15 x (1+0.1)4 + 15 x (1+0.1)3 + 15 x (1+0.1)2 + 15 x (1+0.1)1 + 115 =191.58

This means that our investors will be 30.53 million euros (191.58-161.05) richer in five years, if they
entrust their money to us than they would be if they invested it on their own behalf. That is in the
future, but in terms of present value:

30.53
PV = = 18.95
(1 + 0.1) 5

You might think that this last step is unnecessary. If our investors already know that they are going
to be richer in the future with our intermediation on their behalf, why do they need to know how much
richer in terms of present value?

The answer is simple because it allows them to determine how much their investment is worth at the
moment it is made. To explain this statement let us dramatize it in real time. The course of events
could take place as follows:

 At 10 o’clock on D-day, the investors give us the one hundred million euros and tell us they want
to earn 10%.

 At 11 o’clock, we conclude the deal producing the income specified in alternative 5.

 At 12 o’clock, we tell the investors the deal has been done. 4

As of this moment, the investors know that the hundred million euros in cash they had at ten o’clock
have been turned into a business whose value is €118.95 million. This means that in two hours they
have become wealthier by the difference. This “instantaneous” information is provided by present
value.

These are the basic theoretical underpinnings of investing with talent. The task of a financial director
is to evaluate the business opportunities in which the company is able to invest and to choose that
option which makes the investors wealthiest. If the finance director is able to increase the investors’
wealth, he or she will be considered effective and entrusted with larger tasks. On the other hand, if
the finance director makes investments that increase the investors’ wealth less than they could do
on their own, he or she will find himself or herself looking for another job in the cold outside world.

III.- APPLYING THE BASICS. AN EXAMPLE INVESTMENT APPRAISAL

3
We have to be consistent. If the investors can invest their money at 10%, it means they are investing it year on year; at
the end of the first year they will have 110, (100 x 1.1); at the end of the second year 121, (110 x 1.1) and so on, until the
fifth year. This means that the 10% option is always available. It must therefore always be open to the money we recoup
from our business.
4
We have assumed here that the income from all the alternatives is guaranteed. So far, we have not introduced the factor
of risk because it would complicate the argument. Risk and its quantitative influence on present value will be dealt with in
the next chapter.

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Let us suppose that we have passed the hundred-million-euro test and that the investors, happy with
our management of their money, suggest we look for new business opportunities in which to invest
their money. Let us also suppose we have an opportunity before us, the Gemini Project, which
involves expanding the company’s installations, in order to meet the increase in demand envisaged
for the next five years. The forecast investments and results are as follows:

TABLE 2

Gemini Project End of year

(in millions of euros) 0 1 2 3 4 5

New machinery 96.00

Sales 72.00 79.20 87.12 95.83 105.42

Cost of sales 45.36 49.90 54.89 60.37 66.41
Depreciation 16.00 16.00 16.00 16.00 16.00
Operating profit 10.64 13.30 16.23 19.46 23.00
Taxes 3.72 4.66 5.68 6.81 8.05
Profit after tax 6.92 8.65 10.55 12.65 14.95
Depreciation 16.00 16.00 16.00 16.00 16.00
Cash flow from operations 22.92 24.65 26.55 28.65 30.95
- Investment in cash in hand (1% of sales) 0.72 0.07 0.08 0.09 0.10
- Investment in customers (3 months’ worth of sales) 18.00 1.80 1.98 2.18 2.40
- Investment in inventory (2 months’ worth of costs) 7.56 0.76 0.83 0.91 1.01
+ Supplier finance (3 months’ worth of costs) 11.34 1.13 1.25 1.37 1.51
+ Tax finance (1 year) 3.72 0.93 1.03 1.13 1.24
- Investment in fixed assets 96.00
Net cash flow (FCFO) -96.00 11.70 24.09 25.93 27.97 30.20

Table 2 is a quantitative summary of our project. If we invest €96 million in new machinery,
installations and equipment, we think we can sell €72 million more in the first year, growing by 10%
a year over five years. These new sales will have a cost of 63%, the installations will be amortized
or depreciated over six years and the tax rate applied is 35%. We have also calculated the
requirements for investment in working capital:

 Collection period: Let us suppose that payment for sales is collected three months later, which
means that in the first year, we have to invest 25% of sales in customer receivables. The second
year we would have to invest three months of the increase in sales, i.e., if the sales increase by
7.2% (79.2 – 72), customer receivables will grow by 25% of this €7.2 million, i.e., €1.8 million.

 Payment period: We will pay the cost of sales after three months and taxes the following year. 5

 Cash in hand requirements to cover contingencies have been set at 1% of sales.

 Inventory will be two months’ worth of costs.

5
The procedure is the same as in the case of customer receivables. If what we sell in the first year costs €45.36 million
and what we don’t pay is a quarter (three months), we will owe our suppliers €11.34 million (€45.36m/4). The amount we
owe the following year is equal to this year’s costs divided by four (€49.9m/4=€12.47m) but the difference in finance that
we obtain will only be the increase in supplier payables, i.e., €12.47-€11.34 = €1.13. The same thing happens with taxes.
If in the first year we obtain finance from the state of €3.72 million and the second year €4.66m, the additional finance
obtained in the second year is the difference (€4.66-€3.72=€0.93 million).

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Using these assumptions, we can calculate the free cash flow on operations (FCFO) produced by
the project. This is the money available to our investors. To perform this calculation we have based
ourselves on the model of variation in cash in hand developed in chapter II.

A number of conventions are used in investment analysis which we should state before continuing.
The starting point of the project is referred to as the “end of period 0.” It is not, therefore, an interval
of time, but the moment at which money needs to be made available to commence activity. It can
also be identified with the start of period 1. In each of the following periods, the activities taking place
during the period are concentrated at the end, i.e., sales, costs, taxes, new investments, etc. The
periods do not need to be annual, they can be two-year periods or even just days, as required.
Nevertheless, they must be the same, i.e., you cannot mix annual periods with six-monthly or monthly
ones. Lastly, once the lifetime of the project has been established (five years in our case) an
additional year is generally used to wind up the investment so that once the business activities have
been completed, the residual value of the assets is recovered.

Having now covered these points, we can start our analysis of the Gemini Project. The proposal is
to invest €96 million in new machinery. This investment will be recompensed by additional sales that
will produce the benefits specified in the table. This means that the hundred million euros of the first
investment follow their course and have nothing to do with this €96m. We are doing what is known
as marginal analysis, i.e., studying the relationship between the new disbursements and the new
results solely from the investment.

In chapter I, we analyzed how value is assigned to the money due to be received in the future by
means of future value and present value calculations. Let us now try to apply the reasoning used
there to the data for the Gemini Project.

IV.- THE FUTURE VALUE OF GEMINI

The FCFO represents the generation of cash by the Gemini Project. It comprises profits plus the
costs not representing a payment (in this case depreciation) less the money that needs to be
invested, both in circulating or working capital and fixed assets, to obtain this profit. The series of
FCFOs tells us how much money we are going to pay out and how much money we are going to
receive and when we are going to receive it.

Gemini Project End of year

0 1 2 3 4 5

Free Cash Flow from Operations -96.00 11.70 24.09 25.93 27.97 30.20

Let us analyze the information we already have. We know that if we invest €96 million in Gemini
today, we have the possibility of obtaining a series of FCFO payments over the next five years. Let
us suppose that the investors we represent want to obtain a return of 9% 6. With these data, we can
start to use the knowledge we have acquired so far to determine the value of money over time.

The first thing we have to do is to calculate what the future value of the €96m will be if the investors
place their money at 9% in a hypothetical alternative project. Also, to be consistent, we need to
assume that it will also be possible to invest the money the Gemini Project will produce (FCFO) over
the next five years at this rate of 9% at the moment the payments take place 7. The results are shown
in the table below.

6
The next chapter will be devoted to explaining how to obtain the rate of return required for investment projects depending
on their risk. For the time being we will accept this figure of 9%.
7
The future value of the €96 million at the end of the five years will be 96x1.095 which means that at the end of the first
year the future value will be 96x1.09, at the end of the second year it will be 96x1.092 and so on. This means that option
to deposit the money at 9% is available for the €96 million in each of the next five years. To be consistent means that this
option must also be available for the FCFO from the Gemini Project.

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TABLE 3

0 1 2 3 4 FV in the year 5

96.00 FV = 96x(1.09)5 147.71

11.70 FV = 11.70x(1.09)4 16.52

24.09 FV = 24.09x(1.09)3 31.19
25.93 FV = 25.93x(1.09)2 30.81
27.97 FV = 27.97x(1.09)1 30.49
FV = 30.20x(1.09)0 30.20

139.21

Table 3 allows us to compare the two future values, that of the €96 million invested at 9% over five
years and that of the FCFO payments from the €96 million invested in the Gemini Project. Bearing
in mind that these payments can also be reinvested at 9% for the number of years this is feasible in
each case (the FCFO from the first year can be invested for the four years the alternative investment
lasts, the FCFO from the second year can be invested for three years, and that of the fifth year cannot
be reinvested at all, as there is no time left).

The results indicate that the investors would be better off if they were to invest the €96 million in the
alternative to the Gemini Project, given that the future value of the alternative project is €147.71
million, whereas the sum of the future values of the FCFO payments from the Gemini Project only
come to €139.21 million (bearing in mind the reinvested income). This means that investing in Gemini
would make us less wealthy than we could be by €147.71 - €139.21 = €8.5 million in five years’ time.

We can also reach this conclusion by a different route. If the investors ask for a return of 9% over
five years, our obligation is to give them €147.71 million at the end of the period in return for the €96
million they entrust us with today. If we decided to invest in Gemini we could only give them €139.21
million. Therefore, we cannot undertake the Gemini Project if we want to fulfill our obligation 8.

This is not to say that Gemini is a bad project. Rather we are saying that it is not sufficiently good.
Nor are we saying that it is not profitable, only that it is less profitable than an alternative project
offering a return of 9%.

Future value is a good system with which to choose investments as it enables us to know which of
the alternatives will make us wealthiest in the future. However, it is not the most commonly used
method as financial people prefer the concept of present value, for reasons we will explain later.

8
Remember that in most cases, fulfilling commitments is the fundamental reason for getting paid at the end of the month.

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V.- PRESENT VALUE

The concept of future value is an intuitive concept that answers the question as to which route to
follow in order to increase our wealth. By contrast, present value is more abstract and requires
mathematical thinking to be grasped. However, with our “time machine” we have been able to
transport money into the future, so we should not have any difficulty bringing future money back to
the present. Let us look at how we can do so.

We already know that the rate of return required by the investors (which we shall call i) establishes
a “there-and-back” relationship in time (n) between the future value (FV) and present value (PV).
This means that in mathematical terms, if FV = PV x (1+i)n, then,

FV
PV =
(1 + i ) n

In other words, focusing on our example, if FV = 96 x (1+0.09)5 = 147.71, then,

147.71
PV = = 96
(1 + 0.09) 5

If this is the case, we can also establish this relationship between the FVs and the FCFOs and their
PV. Thus the PV of the FV 9 of the FCFO of the first year will be:

FVn ofFCFO1 16.52

= = 11.70
(1 + i ) n
(1 + 0.09) 5

And the sum of the present values will be,

16.52 31.19 30.81 30.49 30.20 139.21

∑ PV = (1 + 0.09) 5
+
(1 + 0.09) 5
+
(1 + 0.09) 5
+
(1 + 0.09) 5
+
(1 + 0.09) 5
=
(1 + 0.09) 5
= 90.48

Looking at Table 3, this formula could also be written in the following form:

11.70 x1.09 4 , 24.09 x1.09 3 25.93 x1.09 2 27.97 x1.091 30.20 x1.09 0 139.21
∑ PV = (1 + 0.09) 5
+
(1 + 0.09) 5
+
(1 + 0.09) 5
+
(1 + 0.09) 5
+
(1 + 0.09) 5
=
(1 + 0.09) 5
= 90.48

And, if we eliminate the recurring factors from the numerator and denominator, the sum looks as
follows:

11.70 24.09 25.93 27.97 30.20

∑ PV = (1 + 0.09) + (1 + 0.09) 2
+
(1 + 0.09) 3
+
(1 + 0.09) 4
+
(1 + 0.09) 5
= 90.48

9
Note that we are calculating the present value of a future value from the fifth year, and not the present value of a future
value from the first year. This distinction is crucial to understanding how present value should be used.

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This is the formula for calculating PV of a series of cash flows (FCFO) that appears in all the manuals.
Why have we made the effort to move all the FCFO payments towards the future and then back to
the present if we could have found their present values directly using the standard formula? Please
be patient. Let us first analyze the results and then explain this apparently useless trip.

The sum of the present values of the FCFO payments of the Gemini Project is €90.48 million, and
we would need to invest €96 million. What do these figures mean? The answer is simple. Previously,
we said that investing in the Gemini Project would mean there would be a shortfall of €8.49 million
in what we earn for our investors over the five year period when compared with an alternative
investment at 9%. However, the fact that the present value of the FCFOs is less than our investment
needs means that choosing Gemini would cause us to lose money now, to the tune of €90.48m –
€96m = €5.52 million. This implies that making this decision would make our investors poorer by
€5.52 million now 10.

PV is a useful tool with which to attribute value to a series of cash flows. Businesses that work with
cash, such as those that buy and sell in a day, only need two pieces of information: how much the
goods cost and how much they can be sold for. If the price is more than the cost, the transaction
goes ahead, if it is not, it is rejected. What PV does in the case of businesses that work with deferred
payment and so need to make disbursements in the present in order to receive compensation in the
future, is that it gives them the appearance of cash businesses. The PV is what the business is worth.
The initial investment is what it costs to set it in motion. Thus, if what an investment is worth is more
than what it costs, it is accepted. Otherwise, if what it costs is more than what it is worth, it is rejected.
This is the best way to interpret PV, and it leads us on to the most popular concept in investment
analysis, namely net present value.

VI.- NET PRESENT VALUE (NPV)

NPV is the difference between the investment which we have to make at time zero and the PV of the
future cash flows. Expressed mathematically it looks as follows:

n
FCFOn
NPV = − Investment + ∑
1 (1 + i ) n

Which, extended and generalized, becomes:

FCFO1 FCFO2 FCFOn

NPV = − Investment + + + ... +
(1 + i ) 1
(1 + i ) 2
(1 + i ) n

This formula, when investing money at time zero, the FCFOn are the net cash flows of the years the
project lasts and i the rate of return the investors backing the project want to earn, or can earn from
alternative investments. In our example the result would be:

11.70 24.09 25.93 27.97 30.20

NPV = −96 + + + + + = −5.52
(1 + 0.09) (1 + 0.09) 2
(1 + 0.09) 3
(1 + 0.09) 4
(1 + 0.09) 5

10
Obviously, the future value of €5.52m in five years at 9% is €8.50 million and the present value of €8.50 over the same
period at the same rate of return is €5.52m.

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We already know what this negative value of NPV means. Namely, that the money we have to invest
is €4.89 million more than the money we are going to obtain for investing it. Thus, it cannot be
considered an acceptable investment. In general, the NPV represents the difference between what
an investment is worth and what it costs. Therefore, a negative NPV tells us that an investment costs
more than it is worth, and makes it advisable not to make this particular investment as it would make
its investors poorer than they expect to be. A positive NPV implies that an investment is worth more
than it costs and recommends it as it would make its investors better off, and a zero VAN indicates
that the investment is worth what it costs, or in other words, that it produces the same as a
hypothetical alternative investment at 9%.

VII.- THE DISCOUNT RATE

The popular understanding of the calculation of PV or NPV is that of “discounting cash flows.”
Discounting implies reducing or diminishing the value of future money using what is known as the
discount rate (DR). This DR, to which we shall devote the next chapter, is the rate at which investors
can invest their money in other alternative businesses instead of that being evaluated. Applying a
reference rate looks much clearer when we compare the FV of the cash flows from Gemini with the
FV of an alternative investment at 9%. However, given the mathematical correspondence between
FV and PV, the investment rate that converts the PV into FV must be the same as that which converts
FV into PV. Therefore, the discount rate is the return that investors want to obtain from the business
in question because it is what they can earn on alternative investments.

VIII.- A REFLECTION ON NPV: THE CASH-FLOW REINVESTMENT ASSUMPTION

The formula for NPV that we saw in point 6 has the advantage that it is easy to apply. Moreover,
financial calculators and spreadsheets make it easy to use by making it possible to calculate the
result almost effortlessly. This should not cause us to lose sight of the hypotheses on which this tool
is based. When we calculate NPV using the traditional formula we need to bear in mind that it is a
simplification of the original and that the denominators, (1+r) in the first year, (1+r)2 in the second
year etc., take this form because we are assuming that the FCFO payments are reinvested at the
same rate as they are discounted, i.e., at the rate of return that the investors want to obtain. Without
this hypothesis, the NPV formula would be as follows:

FCFO1 x(1 + t ) ( n −1) FCFO2 x(1 + t ) ( n − 2 ) FCFOn −1 x(1 + t )1 FCFOn

NPV = − Investment + + + ... + +
(1 + r ) n (1 + r ) n (1 + r ) n (1 + r ) n

Where the new element t represents the reinvestment rate at which the FCFO can be invested during
the lifetime of the project. The important question is that only when we accept the hypothesis that r
is equal to t can we use the shortened NPV formula. When this is not the case, we should include
the reinvestment rate in the numerators of the formula and change the exponents of the bracketed
elements of the denominators.

To return to our example, let us suppose that we think that we are not going to be able to reinvest
the FCFOs from our Gemini project. In this case, the NPV would be:

11.70 24.09 25.93 27.97 30.20 119.89

NPV = −96 + + + + + = = −18.08
(1 + 0.09) 5
(1 + 0.09) 5
(1 + 0.09) 5
(1 + 0.09) 5
(1 + 0.09) 5
(1 + 0.09) 5

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Obviously, this is less than before because now there is no accrual of interest from reinvestment of
the FCFO.

Let us now make one more assumption. Let us suppose that we have the opportunity to reinvest the
FCFO in a prosperous business that produces a return of 20%. In this case, the NPV would be:

11.70 x1.2 4 24.09 x1.2 3 25.93 x1.2 2 27.97 x1.21 30.20 x1.2 0
NPV = −96 + + + + + = 33.64
(1 + 0.09) 5 (1 + 0.09) 5 (1 + 0.09) 5 (1 + 0.09) 5 (1 + 0.09) 5

That is to say, we have obtained a positive NPV thanks to the reinvestment of the FCFO at a higher
rate than 9%.

In short, you need to be careful when you use NPV and think a moment before you apply the formula.
In particular, you need to decide whether in the particular case you are analyzing you can assume
that the reinvestment rate is the same as the discount rate.

IX.- USING THE INTERNAL RATE OF RETURN (IRR)

Back in chapter I, we defined the IRR as the discount rate that makes the NPV zero. In our example,
we have seen that if we use a rate of 9% as the discount rate the NPV is negative, to the tune of -
€5.52 million. But, what happens if we use a lower rate, for example, 8%? Logically, the NPV would
be higher, i.e., less negative. Specifically, it would be -€2.81 million. If we continue reducing the rate,
the NPV increases until we reach the rate of 7.01% at which the NPV becomes zero. This rate is the
IRR of the project.

The IRR defines a frontier between investments with a positive NPV and those with a negative NPV.
Thus, if we compare discount rates with a project’s IRR we can say that discounting a rate higher
than the IRR implies a negative NPV, and thus that the investment should be rejected. Discounting
a discount rate equal to or less than the IRR implies a zero or positive NPV and an initial
recommendation to embark on the project. This is the same as saying that from the point of view of
the finance director, “If my investors want to earn 9% and the IRR of the project is greater than or
equal to this rate I should undertake the project, because it will enable me to make them as rich, or
richer, than they expect. If the IRR is less than 9% I should not invest in the project because I would
make them poorer than they expect.”

X.- THE DRAWBACKS OF IRR

The internal rate of return is a convenient method for classifying investments. We simply need to
calculate the IRR of the various alternatives and put them in order, from highest to lowest. If we have
a pre-determined discount rate, the investments whose IRRs are higher than the DR will be
acceptable businesses for the company, and of these, if we can only choose one, we will select that
with the highest IRR.

Nevertheless, IRR has two serious drawbacks. The first is that it assumes the cash flows are
reinvested at the same rate as they are discounted. The mathematical definition of the IRR is as
follows:

CF1 CF2 CFn

0 = − Investment + + + ... +
(1 + IRR) 1
(1 + IRR) 2
(1 + IRR) n

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The expression is telling us that in order to calculate the IRR, we need to be able to reinvest the cash
flows at the same rate. This brings us up against the paradox that investments with a high IRR have
a high IRR precisely because we reinvest at that rate, and by contrast, investments with a low IRR
have a low IRR because we reinvest at a lower rate. It would be somewhat like saying “businesses
with large cash flows relative to the initial investment are even better than they appear because we
can reinvest these cash flows at higher rates.” Or, in contrast, “investments with low cash flow rates
relative to the investment are not just disappointing for this reason, it is also that these cash flows
can only be invested at low rates.” This line of reasoning, which is implicit in the IRR calculation is
not entirely convincing, which somewhat undermines IRR’s reliability as a tool.

The second problem is purely a matter of the mathematics of the calculation. IRR works well when
only the initial investment is negative and the cash flows are all positive. But, when positive and
negative cash flows start to get mixed up during the lifetime of the investment, IRR starts to behave
erratically and is of little use. This is due to the fact that linear equations of degree n, i.e., equations
in which the unknown is raised to an exponent n, have as many solutions as the order of the exponent
(second order equations have two solutions, third order equations have three, and so on.) When the
formula has only one change of sign these solutions are the same, but when there are several, the
solutions can be different, and it can turn out that the IRR of an investment is simultaneously 15%
and –12%. When a project gives us an IRR of this kind we clearly cannot use it as the basis on which
to classify projects. In such cases, we have to use NPV, which never causes problems of this sort.

XI.- OTHER METHODS FOR EVALUATING INVESTMENTS

Apart from NPV and IRR, there are a number of other procedures for evaluating investments. They
are simpler but are limited in their predictive capacity. We will describe them below and analyze their
applicability to the Gemini project.

XI.1. ACCOUNTING RATE OF RETURN (ARR)

The ARR or book yield relates the investments to the profits obtained from them. It also uses average
magnitudes based on the number of years of the project’s lifetime. It is defined as the percentage
implied by the average annual profit divided by the average investment during the lifetime of the
project.

Pr ofit average
ARR = x100
Investment average

In our example, the average profit (the sum of the profits divided by five) in relation to the average
investment (book value at the start of each year) 11, would be:

6.92 + 8.65 + 10.55 + 12.65 + 14.95

5 10.74
ARR = x100 = x100 = 16.79%
96 + 80 + 64 + 48 + 32 64
5

The ARR tells us that the average annual profits of the Gemini project are 16.79% of the average
investment, if we assign the project a lifetime of five years.

11
The book value will decrease as €16 million are amortized each year.

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We now have another criterion for selecting investments, namely ARR. It would seem reasonable to
think that investments with an ARR of more than 16.79% will be preferable to the Gemini project and
that those with a ARR less than this would be postponed in its favor.

The fundamental problem with the ARR is that it is calculated using magnitudes that are almost never
homogeneous, i.e., investments and profits. Investments necessarily imply a disbursement of money.
However, profits do not always imply that money is received. Profits represent the money earned in
accounting terms, but do not always represent the money the company actually has in the form of
cash in hand.

Moreover, even if the profits were available the moment they arose, ARR can lead to error in our
assessment of them. Let us suppose that there is an alternative project we could undertake instead
of Gemini, for example, the Apollo project. In the case of Gemini, we have calculated the ARR on
the basis of the following data:

Gemini Project End of year

0 1 2 3 4 5 Average

Profit after tax 6.92 8.65 10.55 12.65 14.95 10.74

Fixed assets 96 80 64 48 32 64.0
ARR 16.78%

However, other investments can also be imagined which have equal disbursements and profits, and
therefore the same ARR, but distributed differently over time, for example in the case of Apollo:

Apollo Project End of year

0 1 2 3 4 5 Average

Profit after tax 20 15 10 5 3.7 10.74

New machinery 96 80 64 48 32 64.0
ARR 16.78%

The two investments have the same ARR, but the Apollo project starts turning a profit before Gemini.
Thus, if in each case the profits are available when they are produced, this would be the better
alternative.

ARR, therefore, seems to classify investments producing different economic outcomes as being the
same, highlighting its potential unreliability as a tool with which to distinguish between investments.

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XI.2. THE PAYBACK PERIOD

The payback period is a calculation of the number of years needed to recoup an initial investment. It
is an easy indicator to calculate and is in widespread use among so-called “intuitive” business people
who tend to view sophisticated calculations in business to be something of a waste of time. The
payback period is usually calculated comparing the investment with the profits, but here we will
compare the investment with the net cash flow. The numbers we need are those at the end of Table
2.

Gemini Project End of year

0 1 2 3 4 5

Cash flow -96 11.70 24.09 25.93 27.97 30.20

Accumulated cash flow -84.30 -60.21 -34.28 -6.31 23.89

We can see by calculating the accumulated net cash flow that the investment is recouped within five
years. A more exact calculation would be:

6.31
4 years + = 4.2 years
30.20

Or approximately four years and two months.

To confirm the reliability of the payback period, we will use the same system as with the ARR, i.e.,
imagining alternative projects that allow us to know if the payback period classifies the investments
correctly.

CFs of Projects: End of year

0 1 2 3 4 5

Gemini -96 11.70 24.09 25.93 27.97 30.20

Pathfinder -96 400.00
Mariner -96 96.0

The table shows three projects. As we have seen, the Gemini project has a payback period of 4.2
years. Pathfinder also has a payback period of 4.2 years and Mariner has a payback period of 1
year.

If we use payback as a measure of the utility produced by the investments, it would put Mariner in
first place and Gemini and Pathfinder tied in second. However, the best project is without doubt
Pathfinder as it produces four-hundred million euros in the final year, making it unbeatable. Mariner
is the worst, as it produces the least money in terms of both quantity and present value. 12

Thus, we see that payback can lead to inconsistencies when used to classify investments. Moreover,
it is not a method which takes into account the profitability of the project but rather its ability to produce
money rapidly as only the FCFOs needed to recoup the investment are taken into account to
calculate it, and the rest are ignored. This means that the payback period is concerned more with
liquidity criteria than profitability.

12
The PV of Mariner is €96m/1.09=€88.07m whereas, as we have seen, the PV of Gemini is €90.48m. Pathfinder has a PV
of €400m/1.095=€259.97

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For all its failings, payback also has its positive features. Although indirectly, it is introducing into the
analysis a factor we have not yet taking into account, namely risk. Of our three projects, the one that
produces most money is undoubtedly Pathfinder, but it obliges us to commit €96 million for over four
years without receiving anything in exchange. Moreover, the Mariner project barely produces any
return at all (indeed its return is negative if we take its present value into account), but it allows us to
recoup our money in a year. If there is a chance that the projects will not reach the end of their lifetime
and the inward flow of money could be interrupted, it may be the case that the most profitable projects
are not the most attractive, on account of the risk they entail.

XII.- A REVIEW OF THE GEMINI PROJECT

We will now round off our analysis of the Gemini project by applying the various different methods
we have used during the course of this chapter. To do so, we will repeat the data given in Table 2,
with a number of references to the residual value postponed from previous stages of the analysis.

The lifetime we have given the Gemini project is five years, after which time we have assumed that
the activity producing the cash flows will cease. However, this does not mean that the assets we
have been using evaporate at the moment the business stops. They are still there and can be
ascribed a value. In some cases, this will be easy to calculate, and in others, there will be a variety
of opinions. Bearing this problem in mind we will try to calculate the residual value of Gemini’s assets.

Apart from the €96 million in fixed assets, the first investment quantified in our project is the
investment in cash in hand. Our forecast is that the cash in hand needs of the project will be 1% of
sales. This obliges us to invest €0.72 million in the first year and 10% more in following years, as
sales grow. This means that at the end of the fifth year, we will have €1.07 million in ready cash that
we no longer need for anything. We can therefore assume that this amount is recouped in full.

The second investment is in customer receivables. In the first year, we leave €18 million uncollected
(three months of sales). In the following years, the quantity increases as turnover grows at a rate of
10% a year until at the end of the fifth year customer receivables stand at €26.35 million. Here we
can either assume that all the customers will pay us once the business activity ends, or that some
will not. In this case, we will be optimistic and expect to recoup 100% of our customer receivables.

The same is not true of the stock that has built up over the years. The book value of the inventory
will be €11.07 million. However, we cannot expect to sell the stock for this value and so will estimate
that a 50% discount will be necessary in order to sell it off at the end of year 6. Selling merchandise
at less than its book value brings us into a new area of analysis, namely the “tax shield” provided by
losses.

If we sell the €11.07 million of inventory for 50% of its book value the money received will be €5.54
million. However, our accounts will also be affected as follows.

Sale of stock (1) 5.54

Book value 11.07
Losses 5.54
Tax shield at 35% (2) 1.94
Variation in cash (1)+(2) 7.48

The book losses caused by selling the inventory will mean that we pay €1.94 million less tax,
therefore the change in cash in hand resulting from this operation will be €3.82 million. This figure
comprises the €5.54 million in cash raised from the sale of stock together with the €1.94 million that
is not paid due to the tax shield provided by the loss incurred.

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Let us continue with our liquidation. We now need to value the finance. Over the lifetime, the suppliers
provide finance for purchases and the state provides finance in the form of the uncollected taxes due
on the project’s profits. When the business ceases, it will be necessary to pay in full all sums owed
to suppliers and the state. The accrued totals due to suppliers and in taxes therefore have to be
deducted from the recouped value in cash, customer receivables and inventory.

Lastly, we have to value the fixed assets, which we will estimate in this case, can be sold with an
increase in value of 400% of their book value. The calculations are as follows:

Initial fixed assets 96.0

Accrued depreciation 84.0
Book value of fixed assets 16.0
Sale price (1) 48.0
Extraordinary profit 32.0
Tax at 35% (2) 11.2
Variation in cash (1)-(2) 36.8

Unlike the case of stock, the amount collected on the sale of fixed assets is reduced by the tax due
on the extraordinary profits arising from the capital gain.

We now have all the items we need to determine the residual value, which are summarized in the
last column of Table IV. Each of the amounts has a negative sign because of the way the accounts
are defined, i.e., investment in cash in hand is negative in the case of residual value because we are
dealing with the recouping of the invested cash. Finance in the form of supplier payables is negative
because this finance is repaid, and the residual value from the investment in fixed assets is negative
because we are again recovering assets. The sum total of the residual value recouped in year 6 is
€47.03 million. At the bottom of Table IV the methods of valuing the investment in the Gemini Project
have been applied in two ways, firstly without and then with the residual value. The conclusions we
can draw from this are as follows:

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Gemini Project End of Year

(million euros) 0 1 2 3 4 5 6
(VR)
New machinery 96.00

Sales 72.00 79.20 87.12 95.83 105.42

Cost of sales 45.36 49.90 54.89 60.37 66.41
Depreciation 16.00 16.00 16.00 16.00 16.00
Operating profit 10.64 13.30 16.23 19.46 23.00
Taxes 3.72 4.66 5.68 6.81 8.05
Profit after tax 6.92 8.65 10.55 12.65 14.95
Depreciation 16.00 16.00 16.00 16.00 16.00
Cash Flow (OCF) 22.92 24.65 26.55 28.65 30.95
- Investment in cash in hand (1% of sales) 0.72 0.07 0.08 0.09 0.10 1.05
- Investment in customer receivables (90 days of 18.00 1.80 1.98 2.18 2.40 26.35
sales)
- Investment in inventory (60 days of costs) 7.56 0.76 0.83 0.91 1.01 7.48
+ Supplier finance (90 days of costs) 11.34 1.13 1.25 1.37 1.51 -16.60
+ Tax finance (1 year) 3.72 0.93 1.03 1.13 1.24 -8.05
- Investment in fixed assets 96.00 36.80
Net cash flows (FCFO) -96.00 11.70 24.09 25.93 27.97 30.20 47.03

Without residual value

Present value of the FCFOs at 9% 90.48

Net present value at 9% -5.52
Internal rate of return % 7.01%
ARR % 16.79%
Payback in years 4.21

With residual value

Present value of the FCFOs at 9% 119.06

Net present value at 9% 20.66
Internal rate of return % 15.25%
ARR % 16.79%
Payback in years 4.21

Neither the ARR nor the payback period takes the residual value into account, the former because it
only considers profits and investment, and the latter because it does not consider cash flows
other than those used to recoup the initial investment.

The PV, NPV and IRR are affected by the inclusion of this new cash flow, making them more sensitive
than ARR or payback to changes in the generation of money by an investment project.

The Gemini Project is very close to being profitable and an increase in the cash flows, in this case
by including the residual value 13, has converted it from being a rejected project to a recommendable
one because the present value is greater than the investment needed, i.e., it is worth more than it
costs, and because its IRR is higher than the discount rate used in alternative projects, in other
words, it gives a better return than that the investors would be willing to accept from similar projects.

13
This could also be due to an increase in sales, a reduction in costs or a lower investment in the circulating capital.

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CONCLUSIONS

In this chapter, we have covered some of the methods most frequently used by finance directors to
decide where to invest the money entrusted to them by their investors. We have tried to show that
accounting methods are imprecise as they do not take into account the way in which businesses
generate money. We have also seen that the payback period can lead us to erroneous decisions
due to the fact that it overlooks the money produced by a business once the investment has been
recouped. Nevertheless, it has enabled us to glimpse the fact that investments which recouped over
the long-term can be risky on account of the uncertainty caused by the remoteness in time of the
profits.

The use of PV has introduced us to the interesting world of asset valuation. How much are the goods
making up a business worth? The money that you think they are going to produce, taking into account
when they are going to produce it and the risk involved. What does a good business consist of? That
it is worth more than it costs, i.e., that the present value of its cash flows (FCFO) is greater than the
price we have to pay for the assets needed to set the business in motion and obtain them.

NPV, which is simply the difference between what an investment costs and what it is worth, enables
us to classify investments whose NPV is positive or zero as recommendable because they are worth
at least as much as they cost and those with a negative NPV as not recommendable, as they are
worth less than they cost.

IRR is obtained by particularizing the mathematical formula used to calculate NPV. It is used to judge
investments in terms of comparative returns. Those investments with an IRR of more than the
discount rate the investors expect are recommendable as they produce a greater return than that
required by the investors. Those that have an IRR less than the discount rate are not recommendable
as they do not produce the rate of return desired by the financial backers of the project.

We have also seen that PV, NPV and IRR implicitly assume that the cash flows (FCFO) are
reinvested at the same rate as that at which they are discounted. This generalization can lead us to
undesirable outcomes when we think that it might not be possible to reinvest the cash flow at the
desired rate.

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