Chapter 6:

Making Investment Decisions

With the Net Present Value Rule

Prof. Ashok Thampy

Corporate Finance
IRIDIUM
 1985 : Iridium project proposed by Bary Bertiger, one of the
brightest engineers in Motorollo
 Proposal: a satellite phone project – requiring 77 satellites,
development of satellite phones; provide phone connectivity
anywhere in the world including deep in the Amazon rain
forest.
 Cost ~ $ 5 billion

 Breakeven number of customers : 250,000 globally

 Project approved by CEO

 Star team assembled for the project

 Competition : Growth of cell phones at low cost and light

handsets; Technical glitch - problem of access inside
buildings
 August 1999: Iridium files for bankruptcy
 Other examples
• RIL investment in Reliance Jio ~ $42 billion
• Hero Motocorp to invest Rs 2,500 crore
including an new plant
• Maruti Suzuki to invest Rs. 4,000 crores in
R&D, product development and network
expansion
• 1000s of others investments – large and small
 Topics Covered

• What To Discount
• IM&C Project
• Equivalent Annual Costs
• Project Interaction
– Optimal Timing
NPV AND CASH TRANSFERS
 Every possible method for evaluating projects impacts the
flow of cash of the company as follows:

Cash

Investment Investment
opportunity Firm Shareholder opportunities
(real asset) (financial assets)

Invest Alternative: Shareholders invest

pay dividend for themselves
to shareholders
 What To Discount

Only Cash Flow is Relevant

 What to discount?
• Only cash flow is relevant
• Always estimate cash flows on an incremental
basis
• Be consistent in your treatment of inflation
• Separate investment and financing decision
 Net income versus Cash Flow

• Net income is easier to manipulate than

cash flows.
• There are cases where net income and
cash flows give very different pictures of a
project.
• When net income and cash flows
conflict, cash flows are much more likely
to reflect reality.
Q. You are advising Winston Groom,

author of Forrest Gump, which

Paramount Productions would like to

turn into a movie. You are negotiating the

contract with Paramount, and they offer

you two choices. Which of the two would

you choose?

* 10% of net profit on the movie

* 1% of the gross revenue on the movie

 Forest Gump and lesson in finance

Produced by Paramount. Released in 1994. Box office collections over $677 million.
Won 6 Academy Awards. Groom was paid $350,000 for the right to the story and
contracted for 3% of profits. Zemeckis (Director) and Tom Hanks contracted for a
share of the box office receipts. Tom Hanks took $40m. The film made no profit.
 Why is profit different from cash
flow?
• In calculating profit, cash inflows from sales
and expenditure is shown as it is earned
rather than when the customers and the
company get around to paying it.
• Income statement and balance sheet are
prepared on accrual basis not based on cash
received and paid.
• In estimating cash flows for capital budgeting,
we need to focus on cash.
 Why is profit different from cash
flow?
• Also, expenditure is divided into
current/operating expenses and capital
expenditure. While operating expenses are
deducted from in calculating profit, capital
expenditure is not deducted as the capital
goods are used by the company over several
years and only a depreciation of the capital
asset is deducted from revenues to calculate
net income or profit during a period.
 Why is profit different from cash
flow?
• Depreciation is a charge that is deducted from
the income which is trying to capture the
decline in value of the capital asset due to
wear and tear. However, there is no cash
outflow due to depreciation.
 Why profit is different from cash
flow?
• Sales revenue in the P&L is booked when the sale is
done, not when the cash is received.
• Similarly, expenses are booked when the expense is
incurred and not when the expense is paid.
• So to get cash flows from the P&L, we have to adjust
for receivables, inventory and payables.
• Capital expenses do not show up on the income
(P&L) statement.
• Depreciation is deducted in P&L but it is not a cash
outflow.
 What To Discount
Points to “Watch Out For”
Estimate Cash Flows on an Incremental Basis
Do not confuse average with incremental payoffs.
Need to focus on incremental cash flow.
Include all incidental effects
Do not forget working capital requirements
Include opportunity costs (alternate use of
existing resource)
Forget sunk costs
Remember salvage value
Beware of allocated overhead costs
Treat inflation consistently
Common mistakes with working capital
• Forgetting about working capital
• Forgetting that working capital may change
during the life of the project
– Ex: Let us say customers pay after 1 months of sale. If sales
in January is Rs. 1 crore, cash payments will be received in
February. The firm’s investment in working capital is Rs. 1
crore. Now if sales increase to Rs. 1.5 crores in February,
total working capital will rise to Rs. 1.5 crores and will
mean an additional investment of Rs. 0.5 crores in working
capital in February.
• Forgetting that working capital is recovered at
the end of the project
 Inflation
INFLATION RULE

➢Be consistent in how you handle inflation!!

➢Use nominal interest rates to discount
nominal cash flows.
➢Use real interest rates to discount real cash
flows.
➢You will get the same results, whether you
use nominal or real figures
 Estimating Cash Flows
Example – IM&C’s Fertilizer Project
Nominal cash flows
Period 0 1 2 3 4 5 6 7
Cap inv -10000 1949
Acc. Dep 1,583 3,167 4,750 6,333 7,917 9,500
Year end book value 10000 8,417 6,833 5,250 3,667 2,083 500
Working capital 550 1289 3261 4890 3583 2002
Total book value(6+7) 8,967 8,122 8,511 8,557 5,666 2,502
Sales 523 12887 32610 48901 35834 19717
COGS 837 7729 19552 29345 21492 11830
Other costs 4000 2200 1210 1331 1464 1611 1772
Depreciation 1,583 1,583 1,583 1,583 1,583 1,583
Profit before tax -4000 -4,097 2,365 10,144 16,509 11,148 4,532 1449
Tax@35% -1400 -1434 828 3550 5778 3902 1586 507
PAT -2600 -2663 1537 6593 10731 7246 2946 942

Note: Interest costs have not been deducted.

 Estimating Cash Flows
• Separate investment and financing decisions
– Evaluate the project as an all equity project.
➔ Interest cost is not deducted in estimating cashflows
– The benefit of debt finance if any should be
considered separately
• Investments in working capital (WKC)
Working Capital = Receivables + Inventory –
Payables
Cash flow is affected by change in WKC
• Depreciation – non-cash charge but reduces
tax (Depreciation provides a tax shield)
 Estimating cash flows
•Free Cash flow of Project at time t =
(PBDITt-Depreciationt)x(1-tc) + depreciationt – investmentst

Investments include investments in working capital and

capital assets (plant and machinery)

Investments in working capital at time t =

(Receivablest – Receivablest-1) + (Inventoryt – Inventoryt-1 )
– (Payablest – Payablest-1)

•Note: We did not deduct interest payments

 IM&C’s Guano Project

Cash flow analysis ($’000s)

Nominal cash flows
Period 0 1 2 3 4 5 6 7
Cap inv -10000 1949
Acc. Dep 1,583 3,167 4,750 6,333 7,917 9,500
Year end book value 10000 8,417 6,833 5,250 3,667 2,083 500
Working capital 550 1289 3261 4890 3583 2002
Total book value(6+7) 8,967 8,122 8,511 8,557 5,666 2,502
Sales 523 12887 32610 48901 35834 19717
COGS 837 7729 19552 29345 21492 11830
Other costs 4000 2200 1210 1331 1464 1611 1772
Depreciation 1,583 1,583 1,583 1,583 1,583 1,583
Profit before tax -4000 -4,097 2,365 10,144 16,509 11,148 4,532 1449
Tax@35% -1400 -1434 828 3550 5778 3902 1586 507
PAT -2600 -2663 1537 6593 10731 7246 2946 942
Cash flow from opern -2600 -1080 3120 8177 12314 8829 4529
Change in WK 550 739 1972 1629 -1307 -1581 -2002
Capital inv and disposal -10000 1442
Net cash flow -12600 -1630 2381 6205 10685 10136 6110 3444
NPV $3,520
 IM&C’s Guano Project
• NPV using nominal cash flows

1,630 2,381 6,205 10,685 10,136

NPV = −12 ,000 − + + + +
1.20 (1.20 ) (1.20 ) (1.20 ) (1.20 )5
2 3 4

6,110 3,444
+ + = 3,520 or $3,520,000
(1.20 ) (1.20 )
6 7
Table 6.2 : Net cash flow estimation using
cash inflow and cash outflow
 Equivalent Annual Cost
Equivalent Annual Cost - The cost per period
with the same present value as the cost of
buying and operating a machine.
 Equivalent Annual Cost
Equivalent Annual Cost - The cost per period
with the same present value as the cost of
buying and operating a machine.
In EAC calculations, since it is calculated to
evaluate investment in machines with unequal
lives, it should be done using real costs/cash
flows.
present value of costs
Equivalent annual cost =
annuity factor
 Equivalent Annual Cost
Given the following costs of buying and operating two
machines and a 6% cost of capital, select the lower
cost machine using equivalent annual cost method.
The production capacity of the two machines are the
same, but A has a life of 3 years and B has a life of 2
years.
Machine 0 1 2 3 PV@6% EAC
A 15 5 5 5 28.37 10.61
B 10 6 6 21.00 11.45
 Equivalent Annual Cost (EAC) and
Inflation
• The EAC is based on real costs of operating the
machines
• Operating cost cash flows are after tax
• The discount rate is also real rate.
• Assumption: machine would be replaced at
the end of its life – assumes replacement cost
increases at the inflation rate
 Timing
• Even projects with positive NPV may be more
valuable if deferred.
• The actual NPV is then the current value of
some future value of the deferred project.

Net future value as of date t

Current NPV =
(1 + r ) t
 Timing
Example
You may harvest a set of trees at anytime over the
next 5 years. Given the FV of delaying the harvest,
which harvest date maximizes current NPV?
Opportunity cost is 10%.
Harvest Year
0 1 2 3 4 5
Net FV ($1000s) 50 64.4 77.5 89.4 100 109.4
% change in value 28.8 20.3 15.4 11.9 9.4
 Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given the
FV of delaying the harvest, which harvest date maximizes current NPV?

64.4
NPV if harvested in year 1 = = 58.5
1.10
 Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given the
FV of delaying the harvest, which harvest date maximizes current NPV?

64.4
N P V if harvested in year 1 = = 58 . 5
1.10
Harvest Year
0 1 2 3 4 5
NPV ($1000s) 50 58.5 64.0 67.2 68.3 67.9