Corporate Finance

Term III, Sections E & F

Class Notes 7

Indian Institute of Management Calcutta

Prof Purusottam Sen

December 2017-March 2018
 Principles of Capital Investment

Generation of investment proposals

Estimation of cash flows for the proposals

Evaluation of cash flows

Selection of projects based on an acceptance criteria

Post – audit and continual re-evaluation of investment projects after

their acceptance
Principles of Capital Investment : Classification of Projects

 Expansion of existing products

 New Products

 Replacement of equipment and buildings

 Research and development

 Exploration

 Others (compliance with health standards, pollution-control

devices)

• Variations in Risk & Return

 Generic Methods of Capital Budgeting

Traditional Methods

 Accounting Rate of Return

 Payback

Discounted Cash Flow (DCF) Methods

• Internal Rate of Return

• Net present value
‘Traditional’ Methods of Capital Budgeting -1

ACCOUNTING RATE OF RETURN (ARR) =

Average annual profit after tax

Total investment in the Project

Acceptance criteria
average rate of return >= required rate of return

Advantages
Simple to use
Needs only accounting information

Disadvantages
Not based on cash flows
Timing of cash inflows outflows ignored
 ‘Traditional’ Methods of Capital Budgeting -2

PAYBACK PERIOD =
Initial fixed investment
Annual cash inflows

Acceptance criteria
Payback period <= maximum acceptable payback period

Advantages
Simple to use
Baised towards liquidity
Some assessment of risk

Disadvantages
Does not consider cash flows after payback period
Magnitude or timing of cash flows during the payback period ignored
Biased against long term projects
 Assessment of Traditional Methods

ADVANTAGES

* Easy to understand
* Easy to compute (with widespread availability of computing
tools this no longer an issue!)
* Ties up with the Financial Accounting System

DISADVANTAGES

* Neglects Time Value of Money

* Subjective
* Risk Analysis limited
 Cash Flow for DCF

• Cash (NOT Accounting) Flows based on incremental

costs/benefits
• Operating (NOT Financing) Effects
• After Tax Flows (incl tax effect of depreciation)
• Include CHANGE in Working Capital
• Salvage Value should be recognised
• Inflation should be considered
• Exclude SUNK costs
• Include opportunity costs
• Include externalities
 Methods of Evaluation : Net Present Value (NPV)

Total duration Cash Flow

in year t
n

 (1  k )
Net Present Value =
At
t
t 0

Required Rate of Return

Acceptance criteria NPV >= 0

 Methods of Evaluation : Internal Rate of Return (IRR)

A1 A2 A3 An
A0     .......... .......... .......... 
(1  r ) (1  r ) (1  r )
2 3
(1  r ) n

or
n At  cash inflow/outflow for period ’n’
A0    t
t 1  (1  r ) 

IRR is the ”r” which equates total discounted cash flow to the
initial outflow

Acceptance criteria  IRR >= Required Rate of Return

Methods of Evaluation : DCF – An Example

Year NCF
0 -18,000
1 5,700
2 5,700
3 5,700
4 5,700
5 5,700

Est. Cost of Capital 12.00%

1. NPV : 2,547.22

2. IRR : 17.57%
 DCF – Project Independence & Dependence

 Mutually exclusive proposals preclude the acceptance

of one or more other proposals (either A or B but not
both)

 Dependant or contingent proposals depends on the

acceptance of one or more proposals (if A then maybe
B)

 Independent proposals do NOT depend on the

acceptance or rejection of one or more proposals (A or
B or both)
 DCF – Relationship between NPV and IRR

INTERNAL RATE OF RETURN

NET PRESENT VALUE

0
5 10 15 20 25 30
DISCOUNT RATE

-
 NPV and IRR –Conflict of Choice
Year NCF-A NCF-B NCF - (A-B)
0 -155.22 -155.22 0
1 0.00 90.00 -90
2 0.00 0.00 0
3 221.00 110.00 111

Terminal Value
Using Opp. Cost of
Capital 221 218.9

Using IRR 221 225.42

Discount Rate 10.00%

NPV 10.82 9.24

IRR 12.50% 13.24% 11.06%
 NPV and IRR – Conflict of Choice
NPV & IRR - Conflicting Signals

80.00

60.00

40.00
NPV

20.00

0.00
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

-20.00

Cross-over
point

-40.00

Project A
Rate
Project B Project (A-B)
 NPV and IRR – Scale of Investment Differences

Cash Flow for Year

Proposal 0 1 IRR NPV(10%)
A -100 150 50 36.36
B -500 625 25 68.18

• Capex available : 500

• Only a single instance of A and/or B can be chosen
• Multiple projects of the same project not allowed
• Any remaining funding must be returned to the corporate pool
 NPV and IRR – Scale of Investment Differences

Cash Flow for Year

Proposal 0 1 IRR NPV(10%)
A -100 150 50 36.36
B -500 625 25 68.18

Scale of investment ignored in IRR ?

Issue to consider : Can the balance 400 of the budget

“saved” if investing in Project A be invested elsewhere?
 NPV and IRR – Project Life Duration

Issue to consider : To have comparable projects, project lives

should be similar – if not identical. If not, one must choose an
appropriate time horizon and then ensure comparability.

Example: replacement decisions

 Multiple IRR’s
Year Cash Flow
0 -1,600
1 10,000
2 -10,000
Multiple Rates of Return
• Multiple IRR’s are possible, if cash-flow stream changes sign
more than once
• Lorrie and Savage problem
• No. of IRR’s are limited to number of sign reversals in the
cash flows
• Change of sign is a necessary but not a sufficient
condition for multiple IRR’s
• Occurrence of multiple IRR’s are dependant on
magnitude of cash flows
 Multiple IRR’s (contd)
Lorrie & Savage Problem

1,500.00

1,000.00

500.00

0.00
NPV

0% 100% 200% 300% 400% 500% 600%

-500.00

-1,000.00

-1,500.00

-2,000.00
Discount Rate
 IRR Vs NPV : Summary

 NPV method produces correct rankings for mutually exclusive

projects
 NPV takes into account the scale of investments
 IRR has the possibility of multiple rate of returns
 IRR method, implied reinvestment rate differs from required rate
 High IRR → high reinvestment rate assumed and vice versa
 Profitability Index
𝐶𝑡
σ𝑛𝑡=1
+ 𝑟)𝑡(1
𝑃𝐼 =
𝑛 −𝐼𝑡
σ𝑡=0
(1 + 𝑟)𝑡

ACCEPTANCE CRITERIA,
PI > 1

Advantages
1 Closely related to NPV,
generally leading to identical
decisions
2 May be useful in capital
rationing situations
Disadvantages
1 May lead to incorrect
decisions in comparisons of
mutually exclusive
investments
 Equivalent Annual Cost
Initial Outlay/
Year Optg Cost (Rs.)
0 1,000,000
1 200,000
2 250,000
3 300,000
4 350,000
5 400,000

Present Value 2,101,247.43

Years : 5
Inerest rate : 10.00%

Capital Recovery Factor (assuming 5years life and

discount rate : 10.00 %) :- CRF = 0.26380

Equivalent Annual Cost = 2101247.43 * 0.2638 = 554,304

 Discounted Pay Back
PV of Cash Cumm. PV of
Year PV Factor * Cash Outflow Outflows Cash Outflows
1 0.87719 10,000 8,772 8,772
2 0.76947 8,000 6,156 14,928
3 0.67497 24,000 16,199 31,127
4 0.59208 15,000 8,881 40,008
5 0.51937 12,000 6,232 46,241

PV of Cash Cumm. PV of
Year PV Factor * Cash Inflow Inflows Cash Inflows
1 0.87719 0 0 0
2 0.76947 16,000 12,311 12,311
3 0.67497 36,000 24,299 36,610
4 0.59208 39,000 23,091 59,702
5 0.51937 24,000 12,465 72,166

* Discount Rate : 14%

Problem : May reject
DPB = 3.42 positive NPV projects
 Inflation

Options :

1. Forecast cash-flows after assessing future inflation +

use discount rates with inflation expectation
2. Forecast cash flow in today’s price levels + exclude
inflation expectation in discount rates
 Capital Rationing -1

• Selection of projects is at any point constrained by

budget ceilings on investments
• Less profitable proposals may be selected to utilize the
full budget
• Even profitable proposals not selected due to lack of
budget
 Capital Rationing -2

Budget Outlay : 25

Project Outlay PV NPV PI

A 25 29 4 1.16
B 15 18 3 1.20
C 10 12 2 1.20
D 16 20 4 1.25

For complex situations involving Capital Rationing & Project Dependence – use
Integer Linear Programming Solution
Capital Rationing –Mathematical Programming Approach -1
n - projects ALL independent
m – life of the longest project
xj – fraction to be invested in the jth project
aj – NPV of the FULL j project
aij – outlay required by project j during period i
bi – Budget ceiling for period I

MAX Z, a1x1 + a2x2 + a3x3 +…………….+ anxn

Subject to :
a11x1 + a12x2 + a12x3 +…………….+ a1nxn  b1
.
am1x1 + am2x2 + am2x3 +…………….+ amnxn  bm
Mathematical Programming Approach - Project Indivisibility

xj may be a fraction, but the decision criteria maybe

“ACCEPT ALL OR NOTHING”. In addition it may be necessary
to rule out multiple occurrences (say when xj=3)

REQUIRED : INTEGER LINEAR PROGRAMMING

0  x j  1, where xj is an INTEGER
 Modified IRR
Reinvestment Rate : 10.00%

Project A Project B

Year Cash Flow Reinvested @%10 Cash Flow Reinvested @%10

0 -100 -100
1 10 14.641 60 87.846
2 30 39.930 60 79.860
3 60 72.600 10 12.100
4 60 66.000 10 11.000
5 20 20.000 10 10.000

213.171 200.806

IRR 20% 24%

NPV 32 25
MIRR 16% 15%
Notes
• Variation : MIRR can be computed with a re-investment rate (for cash inflows) and
a financing rate (for cash outflows)
• The issue of reinvestment is controversial, a significant amount of financial
literature seems to be against its use
Meyer, Richard L. A Note on Capital Budgeting Techniques and the Reinvestment Rate The Journal of Finance, Vol. 34, No. 5 (Dec., 1979), pp.
1251-1254
 Evaluation Techniques

Source : John R. Graham, Campbell R. Harvey, The theory and practice of corporate finance: evidence from the
field, Journal of Financial Economics, Volume 60, Issues 2-3, May 2001, Pages 187-243,