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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

1
Introduction
Contents
1. Investments, discounting, rates of return– introduction ............................................2
1.1. Basic definitions .....................................................................................................2
Time, risk and opportunity costs (cost of delaying the consumption). ..............................6
Investments, speculation and gambling ...........................................................................8
1.2. Classification and features of investments ..........................................................9
Place of investments in balance sheet (statement of financial position) .......................... 11
1.3. Capital investments: ............................................................................................ 13
1.4. Financial Investments .......................................................................................... 15
1.5. Types and features of investors ......................................................................... 17
1.6. How to make an investment decision: economic profit and cash flows, return
of investment, present value of investment and rate of return .................................. 18
Main criterion in investment activity ............................................................................. 18
1.7. Time value of money ........................................................................................... 19
1.8. Rates of return – measuring relative performance of investment ................... 22
1.9. Exercises .............................................................................................................. 27

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

1. Investments, discounting, rates of return– introduction

1.1. Basic definitions

DISCUSSION
How would you define investment?
What examples of investment can you name?

The word 'investment' originally comes from the Latin word 'investire', which means
'to clothe'.
Investment can be defined as an intertemporal exchange of something valuable,
usually represented by cash flows.
Other definitions:

• the transformation of capital (liabilities side of the balance sheet) into assets
(assets side of the balance sheet),

• the process of combining assets, especially capital equipment, into new


goods, in particular production facilities,

• the long-term commitment of financial resources, which in consequence


constrains the freedom of action of the investing company during that
particular period.1

• an outlay that is expected to benefit in the future.2

The aim of investments is to maximise shareholder value.


It is the primary goal for managerial decisions; considers the risk and timing
associated with expected earnings per share in order to maximize the price of the
firm’s common stock.3

1
S. Serfas, Cognitive Biases in the Capital Investment Context, Gabler Verlag | Springer Fachmedien Wiesbaden
GmbH 2011, p. 9-10.
2
N. Seitz, M. Ellison, Capital Budgeting and Long Term Financing Decisions, Thomson. South-Western, 2005, p.
14.
3
E. F. Brigham, J. F. Houston, Fundamentals of Financial Management, 11th edition, Thomson South-Western,
Mason, 2007, p. 6.

2
Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

Fig. Factors influencing the value of the firm


Source: R. Pike, B. Neal, Corporate Finance and Investment. Decisions & Strategies,
Pearson Education Limited, Harlow 2006, p. 18

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

The ‘enlightened shareholder value’ (ESV) approach represents an attempt to


strike a balance between shareholders’ primacy and corporate stakeholders’
interests. Effective corporate social responsibility management is not incompatible
with shareholder value and having wider interests can be the key to long-term
financial performance.4

Environment Society

Governance

Fig. ESG factors in maximizing firm’s value

Whether directors’ duties should be broadened to include stakeholders’ interests as


well.

There is no law or legal principle that could make directors and managers so loyal to
shareholders that they would serve their interests unquestionably, the management
team should be free from any shareholder constraints and be encouraged to become
servants of the community instead (Dodd 1935)

ESV is a hybrid approach which, while retaining the shareholder primacy paradigm,
requires long-termism and promotes welfare for all the stakeholders
(Fisher 2009).

4
S. Andreadakis Enlightened Shareholder Value: Is It the New Modus Operandi for Modern Companies?, S.
Boubaker et al. (eds.), Corporate Governance, Springer-Verlag Berlin Heidelberg 2012, pp 415-432

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

DISCUSSION (T,R, OC)


You did some work and you are to be paid for that. The employer proposes you that
he pay you 2000 EUR today or – if you’ll wait one year – he will pay you 2100 EUR.
Would you agree?
If not, then how much would you like to get?
........
Why?
.......

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

Time, risk and opportunity costs (cost of delaying the consumption).

1. Time is one of central characteristics of investment process:

Usually the time frame for investments exceeds one year:


Up to one year – business activities, short term decisions
Over one year – capital investments

However there can be exceptions, i.e. investments of speculative nature.

2. Risk
Risk is one of central characteristics to investment. If you delay your consumption in
hope for future benefits, some level of risk is always involved.

Certainty: Perfect certainty arises when expectations are single-valued: that is, a
particular outcome will arise rather than a range of outcomes.

DISCUSSION
Is there such a thing as an investment with certain payoffs?
.....

Risk and uncertainty:


Risk refers to the set of unique consequences for a given decision that can be
assigned probabilities.
Uncertainty implies that it is not fully possible to identify outcomes or to assign
probabilities.
Perhaps the worst forms of uncertainty are the ‘unknown unknowns’ –
outcomes from events that we did not even consider.5

Risk is defined as:


• the chance of losing money,
• the chance of getting back less than was expected (compare to opportunity
cost).6

Risk can be measures as a risk premium above the risk-free rate (RFR).
Studies indicate that the long-term average return on an investment portfolio
consisting of the market index (e.g. the FTSE-100) is up to 6 percentage points
higher than that from holding risk-free government securities.7

5
: R. Pike, B. Neal, Corporate Finance and Investment. Decisions & Strategies, Pearson Education Limited,
Harlow 2006, p. 196
6
N. Seitz, M. Ellison, Capital Budgeting and Long Term Financing Decisions, Thomson. South-Western, 2005, p.
345.
7
R. Pike, B. Neal, Corporate Finance and Investment. Decisions & Strategies, Pearson Education Limited,
Harlow 2006, p. 16.

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

Fig. The risk–return trade-off


Source: R. Pike, B. Neal, Corporate Finance and Investment. Decisions & Strategies,
Pearson Education Limited, Harlow 2006, p. 16.

DISCUSSION
Think of sources of risk in investment:
.....

Examples of risk in investment:


- business risk (sales, prices, profits)
- financial risk (liabilities structure, debts, liquidity)
- stock liquidity risk

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

3. Opportunity cost

It measures the value of what society must forgo to use the input to realise the
investment.
In case of investment it’s sometimes referred to as cost of capital.

DISCUSSION
Think of examples of OC in investment:
.....

Investments, speculation and gambling

Speculation:
Gaining profits due to change in price
purchasing (or selling) goods for re-purchase (reselling) based on future price
changes expectations or transfer between markets

Gambling:
Deliberate undertaking new risks, creating of risks

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

1.2. Classification and features of investments

Traditional division of investment:

1. Capital (real) investments


CI can be divided into:
• physical investments – for example machinery, facilities, real estate
property, etc.
• intangible investments – not physical in nature and not serve as
claims for payment by some other party but are expected to result in
future benefits. Intangible investments are for instance research and
development, competitive intelligence or training and education of
employees.8

2. Financial investments
FI include all types of securities (financial assets) – for example stock, bonds,
derivatives, equity stakes, etc. – and can be of speculative or nonspeculative
nature.
Financial asset is a claim against some other party for monetary payment.
Financial assets can be defined as intermediary investments because they
have value usually because money was used for some other asset that will
provide cash flows.
We also use term security here:
Security is a legal representation of the right to receive prospective future
benefits under stated conditions.9

When making investment decision we do:


• security analysis – in case of financial investments – which is a process of
identification of mispriced securities by determining their prospective future
benefits, the conditions under which they will be received and the likelihood of
such conditions.
• project appraisal – in case of capital investments – which is a process of
assessing whether an investment project is worthwhile or not and consist of
following activities:
1. Determine investment funds available
2. Identify profitable project opportunities
3. Evaluate the proposed projects
4. Approve the selected project
5. Monitor and control the project

The outcome of the analysis is assessing investment effectiveness and the decision
to buy security/accept the project if the investment is worthwhile.

8
S. Serfas, Cognitive Biases in the Capital Investment Context, Gabler Verlag | Springer Fachmedien Wiesbaden
GmbH 2011, p. 13.
9
W. Sharpe, G. Alexander, J. Bailey, Investments, 6th ed., Prentice Hall, Upper Saddle River, New Jersey 1999,
p. 3.

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

Investment decisions:
a) single investment
b) choosing the best alternative
c) portfolio of investments

Strategy and
Goals

Investment Choice

Financing Sources
Risk and Required
Return

Fig. Factors influencing investment decision

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

Place of investments in balance sheet (statement of financial position)

CAMPARI GROUP - Consolidated Balance Sheet (Assets) -


IAS/IFRS

millions of Euro 2014


IAS/IFRS
ASSETS
Non-current assets
Net tangible fixed assets 441,5
Biological assets 17,5
Investment property 1,5
Goodwill and brands 1 841,0
Intangible assets with a finite life 29,8
Investments in affiliates and joint ventures 0,8
Deferred tax assets 19,1
Other non-current assets 56,7
Total non-current assets 2 407,7

Current assets
Inventories 477,0
Current biological assets 4,1
Trade receivables 313,6
Short-term financial receivables 22,8
Cash at cash equivalents 230,9
Receivables for income taxes 13,0
Other receivables 26,7
Total current assets 1 088,2

Non-current assets for sale 21,9

Total assets 3 517,7

http://www.camparigroup.com/en/investor-relations-eng/financial-highlights/balance-
sheet

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

CAMPARI GROUP - Consolidated Balance Sheet (Liabilities and


Shareholders' Equity) - IAS/IFRS

millions of Euro 2014


IAS/IFRS
LIABILITIES AND SHAREHOLDERS' EQUITY
Shareholders' equity
Share capital 58,1
Reserves 1 516,8
Group's shareholders' equity 1 574,8
Minorty interests 5,1
Total shareholders' equity 1 579,9

Non-current liabilities
Bonds 1 086,9
Other non-current financial payables 25,8
Defined benefit plans 9,4
Provision for risks and charges 37,9
Deferred tax liabilities 266,2
Total non-current liabilities 1 426,1

Current liabilities
Payables to banks 36,7
Other financial payables 117,4
Payables to suppliers 223,2
Current payables to tax authorities 4,9
Other current liabilities 127,9
Total current liabilities 509,9

Total liabilities and shareholders' equity 3 517,7

http://www.camparigroup.com/en/investor-relations-eng/financial-highlights/balance-
sheet

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

1.3. Capital investments:

Types of assets in capital investments: 10


1. Fixed operational assets of enterprises
2. Real estates
Commercial properties – real estates that generate profits (housing properties,
shopping centres, office centres, hotels, industrial properties, others)
3. Infrastructure
- Commercial/economic infrastructure (roads, railroads, airports, power
stations, telecommunications, etc.)
- Social infrastructure (schools, kindergartens, museums, hospitals
4. Goods/commodities
- Energy sources (oil, gas)
- Metals (gold, copper, silver)
- Agriculture products (corn, wheat, sugar, cocoa)
- Live stock
- Others (water, wood, etc)
5. Collecting commodities
- Antiques
- Art
- Coins
- Post stamps
- Jewellery
- Wine
- Luxury commodities (race horses, sport teams etc)
6. Natural capital
- Climate protection
- Biodiversity
7. Human capital
- Learning
- Health care
- Research
8. Social capital
- bonding – emotional close relationships
- bridging – between-group communication

10
K. Marcinek, Wprowadzenie do inwestowania, Wydawnictwo Uniwersytetu Ekonomicznego w Katowicach,
Katowice 2014, pp. 60-135.

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

Project’s classification according to aim

1. Replacement proposals are justified primarily by the need to replace assets


that are nearly exhausted or have excessively high maintenance costs. Little
or no improvement may be expected from the replacement, but the
expenditure is essential to maintain the existing level of capacity or service
(e.g. replacement of vehicles).

2. Cost reduction proposals are intended to reduce costs through addition of new
equipment or modification to existing equipment.

3. Expansion or improvement proposals relate to existing products, and are


intended to increase production, service and distribution capacity, to improve
product quality, or to maintain and improve the firm’s competitive position.

4. New product proposals refer to all capital expenditures pertaining to the


development and implementation of new products.

5. Strategic proposals are generated at senior management level and involve


expenditure in new areas, or where benefits extend beyond the investment
itself. A project may appear to offer a negative net present value and yet still
create further valuable strategic opportunities.

6. Statutory and welfare proposals do not usually offer an obvious financial


return, although they may contribute in other ways, such as enhancing the
contentment, and hence productivity, of the labour force. The main
consideration is whether standards are met at minimum cost. 11

Features of capital investments outlays:


- Large scale
- Irreversibility of a decision
- Uncertainty

11
R. Pike, B. Neal, Corporate Finance and Investment. Decisions & Strategies, Pearson Education Limited,
Harlow 2006, p. 185

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

1.4. Financial Investments

Financial markets
Security market or financial market is any mechanism for trading financial assets or
securities. It is a mechanism that brings together buyers and sellers of financial
assets in order to facilitate trading.

Financial markets

Money markets Capital markets


Assets that expire in one Assets with life spans of
year or less greater than one year

Fig. Classification of financial market

Division of financial markets:

1. money market - wholesale funds, usually for less than one year, channelled from
lenders to borrowers.
The market is largely dominated by the major banks and other financial
institutions, but local government and large companies also use it for short-
term lending and borrowing purposes.

2. securities (capital) market deals with long-dated securities such as shares and
loan stock.
The London Stock Exchange is the best-known institution in the capital
market, but there are other important markets, such as the bond market (for
longdated government and corporate borrowing) and the Eurobond market.

3. foreign exchange market (FOREX) is a market for buying and selling one
currency against another. Deals are either on a spot basis (for immediate delivery) or
on a forward basis (for future delivery).

4. derivates market is a market where financial futures and options are exchanged.
Derivatives are securities traded separately from the assets from which they are
derived
Future is a tradable contract to buy or sell a specified amount of an asset at a
specified price at a specified future date
Option is the right but not the obligation to buy or sell a particular asset

Financial market main function is “price discovery”, which means to cause security
prices to reflect currently available information.

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

Security is a legal representation of the right to receive prospective future benefits


under stated conditions.12

Types of securities:
1. Treasury Bill – loaning money on a short term basis to the Government
Treasury, Bills can be also issued by Central National Banks to regulate the
money supply on the market. These securities are short term (up to one year)
and carry very little risk. They are often referred as risk-free assets.

2. Bond – fairly long-term commitment on the part of issuer (the borrower) to the
investor (the lender) involving cash payments each year (the coupon amount)
up to some point of time (the maturity date), when a single final cash payment
(the principal) will also be made.
Bonds can be divided into: government bonds, municipal bonds and corporate
bonds)

3. Stock – a commitment on the part of a corporation to pay periodically


whatever its board of directors (general meeting of shareholders) deems
appropriate as a cash dividend
Stock can provide substantial returns, higher than bonds, however the
risk involved is also considerable – the dividend can vary substantially
from one year to another.
Stock (shares) can be divided into common stock and preferred stock,
where the dividend can be stable in time.
Earnings per share Profit available for distribution to shareholders divided by
the number of shares issued

4. Derivative financial instrument (derivates) - financial instruments whose


values are derived from one or more underlying assets, market securities or
indices. It is a contract between two parties that specifies conditions under
which payments are to be made between the parties. (the conditions include
the dates, resulting values, definitions of the underlying variables, the parties'
contractual obligations) Examples of derivates are: forward, option, swap,
interest rate caps. They can be divided into “lock” or “option” products.

Financial institutions (e.g. pension funds, insurance companies, banks, building


societies, unit trusts and specialist investment institutions) act as financial
intermediaries, collecting funds from savers to lend to their corporate and other
customers through the money and capital markets, or directly through loans, leasing
and other forms of financing.13

12
W. Sharpe, G. Alexander, J. Bailey, Investments, 6th ed., Prentice Hall, Upper Saddle River, New Jersey 1999,
p. 3.
13
R. Pike, B. Neal, Corporate Finance and Investment. Decisions & Strategies, Pearson Education Limited,
Harlow 2006, p. 26.

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

1.5. Types and features of investors

K. Marcinek divides investors according to: 14


1) professional capital management - Individual and institutional investors
a) Individual investors – households, individuals that make investments on their
own behalf.
Features: Small scale, wide range of amount invested, diversity of assets
- Individual investors on financial markets (usually undiversified portfolios, small
scale, miss-informed, irrational decisions)
- Individual investors - business angels (investments in innovative firms, start-
ups, seeding
b) Institutional investors – financial institutions gathering funds to invest in
various assets on their own behalf and on other’s behalf.
Features:
- Diversified portfolio
- Long-term fund management (cf. pension funds)
- Large scale
- Better information
- Lower transaction costs
Banks, investment funds, insurance companies, venture capital funds, pension
funds, government

2) source of capital:
Domestic investors,
Foreign investors:
- Foreign direct investments (FDI) via green field investments or acquisitions
- Foreign portfolio investments (FPI) via financial instruments short term
purchase
- international investors (world bank, regional development banks and other
development financial institutions (DFI)

14
K. Marcinek, Wprowadzenie do inwestowania, Wydawnictwo Uniwersytetu Ekonomicznego w Katowicach,
Katowice 2014, pp. 136-

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

1.6. How to make an investment decision: economic profit and cash


flows, return of investment, present value of investment and rate of
return

Main criterion in investment activity

The basic criterion for investment decision making is wealth maximization.


An action increases wealth if the benefits gained exceed the benefits expanded.
Benefits are usually measured as money gained and give up (cash inflows and cash
outflows).15

If the wealth increases through the investment process, the company that invest also
gains value. At the end, the wealth of a shareholder rises.

The process of taking investment decision comprises of: 16


1. Determining the outlays of the investment
2. Determining cash flows and terminal value
3. Assessing risk of cash flows
4. Estimating cost of capital
5. Calculating present value of expected cash flows
6. Comparison between outlays and discounted cash flows.

If present value of CF > present outflows, then the investment increases


investor’s wealth.
If present value of CF = present outflows, then the investment does not
influence investor’s wealth.
If present value of CF < present outflows, then the investment decreases
investor’s wealth.

Economic profit vs financial profit

Financial profit is when inflows exceed outflows (compare profit and loss account,
company earnings calculation).
In economics, the wealth (economic profit) is created if cash inflows exceed cash
outflows by more than what we would have earned if we invested the money
somewhere else during that period (OC).

15
N. Seitz, M. Ellison, Capital Budgeting and Long Term Financing Decisions, Thomson. South-Western, 2005, p.
4.

16 Brigham 296

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

1.7. Time value of money

Reasons why money changes value in time:

• preference for current consumption


• opportunity cost (and possible return on alternative investment),
• risk,
• inflation.

Compounding – is the payment of “interest on interest”. At the end of each period


(compounding interval) interest is computed and added to the principal. This sum
becomes the principal on which the interest is computed at the end of the next
interval.17

1. No compounding – simple interest:

a) Calculating future value and present value for one period (year):

FV
FV  PV 1  r  PV 
1  r 
b) Calculating future value and present value for n periods:

FV
FV  PV 1  nr  PV 
1  nr 
where:
FV – the future value of money
PV – the present value of money
r – the interest rate or rate of return per period
n – number of periods (years) of investment

2. Compound interest

a) Calculating future value and present value for n periods:

FV  PV 1  r 
FV
PV 
n

1  r n

17
W. Sharpe, G. Alexander, J. Bailey, Investments, 6th ed., Prentice Hall, Upper Saddle River, New Jersey 1999,
p. 3.

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

3. More frequent compounding and annual percentage rates

m n
 r FV
FV  PV 1   PV  mn
 m  r
1  
 m

FV  PVe nr PV  FVe  nr

4. Annuity

Annuity (A) is a payment done each period.

Ordinary (Deferred) Annuity - Payments occurring at the end of each period.

Annuity Due - An annuity whose payments occur at the beginning of each period.

DISCUSSION
Think of examples of investments where annuities emerge:
.......

a) The future value of annuities:

Ordinary Annuity:
n
FVA  A1 1  r   A2 1  r     An   Aj 1  r 
n 1 n2 n j

j 1
A – payment at the end of period j

FVA  A
1 r 1
n

for A1  An  A
r
FV of Annuity Due

FVAdue A
1 r 1
n
1  r 
r

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

b) The present value of annuities:


n
1 1 1 1
PVA  A1  A2    An   Aj
1  r 1
1  r 2
1  r  j 1 1  r  j
n

A1  An  A PVA  A
1 r 1
n

for
r 1  r 
n

PV of Annuity Due

PVAdue  A
1  r n  1 1  r 
r 1  r 
n

Perpetuity - a stream of equal payments at fixed intervals expected to continue


forever.
Consol - a perpetual bond

P
PVperpetuity 
r

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

1.8. Rates of return – measuring relative performance of investment

Profits can be measures in absolute terms (EUR, PLN or other currency).


However, if we want to compare two investments, we could use rate of return
(return) and measure profits in relative terms.

end - of - period wealth  beginning - of - period wealth


return 
beginning - of - period wealth

Rate of return is measured in %

Market rate of return

Price ( %)
B

r E

C D
0
QE A Capital

Fig. 8. Capital market and capital price – interest rate

Quoted interest rate comprise of a real risk-free rate of interest, r*, plus several
premiums:18

18
E. F. Brigham, J. F. Houston, Fundamentals of Financial Management, 11th edition, Thomson South-Western,
Mason, 2007, p. 180-181.

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

Quoted interest rate = r = r* + IP + DRP + LP + MRP

r - the quoted, or nominal, rate of interest on a given security,


r*- the real risk-free rate of interest.
r* is pronounced “r-star”. real risk-free rate is the rate that would exist on a
riskless security in a world with no inflation.
rRF - the quoted rate on a risk-free security such as a U.S. Treasury bill or bonds
issued by governments, which are both very liquid and also free of most types of risk.
rRF = RFR = r* + IP
IP - inflation premium.
IP is equal to the average expected inflation rate over the life of the security.
The expected future inflation rate is not necessarily equal to the current
inflation rate, so IP is not necessarily equal to current inflation
DRP - default risk premium.
This premium reflects the possibility that the issuer will not pay interest or
principal at the stated time and in the stated amount. DRP is zero for Treasury
securities, but it rises as the riskiness of the issuer increases.
LP - liquidity (or marketability) premium.
This is a premium charged by lenders to reflect the fact that some securities
cannot be converted to cash on short notice at a “reasonable” price. LP is very
low for Treasury securities and for securities issued by large, strong firms, but
it is relatively high on securities issued by small, privately held firms.
MRP - maturity risk premium.
Longer-term bonds, even Treasury bonds, are exposed to a significant risk of
price declines due to increases in inflation and interest rates, and a maturity
risk premium is charged by lenders to reflect this risk.

The real risk-free rate is not static—it changes over time depending on economic
conditions, especially:
• objective factor: on the rate of return corporations and other borrowers
expect to earn on productive assets, or long term real growth rate of the
economy,
• And, subjective factor: on people’s time preferences for current versus
future consumption, impatience.

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

http://www.aspenwealthmanagement.co.uk/Content/uploads/Barclays_Equity_Gilt_st
udy_2011.pdf

Fig.. Risk premium – international comparison


Source: R. Pike, B. Neal, Corporate Finance and Investment. Decisions & Strategies,
Pearson Education Limited, Harlow 2006, p. 253

Fisher equation (inflation rate):

1  in  1  ir 1  ii 

Or using inflation premium:

in  ir  IP

inflation rate ≠ inflation premium

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

Determinants of interest rate:

∆ in capital supply: ∆ in demand for capital:


- Willingness to save - rate of return on capital
- Personal disposable income investments in the economy
- Real interest rate on deposits - demand for goods and services
- Variety of saving offer - loans interest rates
- Monetary policy - central bank interest rate policy
- fiscal policy

DISCUSSION:
What changes in each determinant can increase market interest rate and how?

Total Shareholder Return (TSR)


percentage return from holding its shares. It is return achieved from all stocks in
possession of a shareholder:

D jt  Pjt  Pjt 1 
TSR  R jt 
Pjt 1
Djt – dividend per share paid by company j in period t,
Pjt – share price of company j at the end of period t
Pjt-1 – share price of company j at the beginning of period t

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

Calculating rate of return from investment

a) Holding Period Yield (HPY)


no compounding
HPY is a rate of return on investment for one period, that equals to the life cycle of
the investment. The period can be one year or longer (2, 4, 7 years etc.) or shorter (2
days, 4 months etc.)

FV  PV FV
HPY   1
PV PV

b) Annualized return no compounding


FV
1
HPY PV
rNP  
n n
c) Annualized return with compounding
Rate of return (most commonly used)

1
 FV  n
r   1
 PV 
d) Annualized return with continuous compounding
ln FV  ln PV
r
n

e) Effective Annual Interest Rate


i
ie 
m
m
 i 
ier  1    1
 m
ie – effective rate of interest in period
ier – effective annualized rate of interest
i – nominal annualized rate of interest
m – frequency of compounding per year

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

1.9. Exercises

1. You open an account in a bank. You make a saving deposit for 2 000 PLN. The
interest rate is 10% annually. How much will you get from the deposit if you:
a) Take out the money after one year
b) Take out the money after 2 years and the Bank:
- adds the interest to principal (the money you paid at the beginning)
- do not add the interest to principal

2. You want to go on a trip to India in 2 years. The trip will cost you 7 000 PLN. You
can open a saving deposit in a Bank at interest rate 4%. How much you deposit
today to have enough money for a trip?

3. You want to finance your children (future children) college education in 20 years
from now. Now it cost 25 000 PLN and it is predicted, that the cost will grow at 3%
annually.
a) How much will the cost be after 20 years?
b) How much should you deposit now, if your Bank offers you a rate of interest equal
to 5%?

4. You currently are in position where you can put 100 000 PLN into a retirement
account. If you choose the retirement account, you can earn 8%. How long it will
take you to reach the amount of 500 000 PLN on your account?

5. How much will the investor earn if he invests 1000 PLN for 8 years at a rate of
5%? How much will he earn if the rate increase by 20%?

6. The investor bought shares worth today 4 000 PLN. He will earn 15 PLN of
dividend each year and after 3 years he will sell shares. He predicts that shares
will be worth 5 200 PLN. The investor can also choose alternative investment,
which give him 8% of interest annually. Should he buy the shares? What is his
total shareholder return on this investment?

7. What rate of return should you seek if you want to double your money in 3 years?

8. The investor is buying securities worth today 5000 PLN. He plans to sell them for
6000 after one year. What is rate of return from the investment? Is it efficient (how
much is economic profit)?

9. Calculate rate of return as


a) HPY
b) Annual rate of return without compounding
c) Annual rate of return for interest compounded once a year
for the data below:
PV = 10 000
FV = 30 000
n = 5 years

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

10. Suppose you want to invest some money, let’s say 1000 EUR. You can choose
between two options, but you can invest all your money into only one of those
two.
Try to guess which option is better (more profitable) and circle it.
Then, calculate annualized rates of return a) simple (no compounding); b) with yearly
compounding; c) continuous compounding

Option A Option B Options are equal/


No You You I'm indifferent
receive receive
after after
Value …years Value …years
1 1 500 3 5 000 7
2 1 100 1 2 000 10
3 1 100 1 2 600 10
4 2 000 7 70 000 60
5 2 000 5 2 000 000 150

11. Discount rates in following months were:


Month 1 2 3 4 5 6 7 8 9 10 11 12
rate (p.a., %) 7 8 9 9 10 9 8 7 7 8 8 10
Calculate FV of 1000 assuming compounding made quarterly. Calculate
Effective Annual Interest Rate?

12. Economic profit vs financial profit


Last year the company invested 500 000 EUR. The company gained revenues worth
100 000 EUR. The expenses were 50 000 EUR, tax equals 20% of EBT (earnings
before tax). The company could earn elsewhere 25 000 EUR (net of tax) (it is
alternative investment or OC).
Calculate economic profit.

13. Total Shareholder Return


Calculate total shareholder return if you had in your portfolio last year 4 shares and
their prices at the beginning and end of last year and the dividends were as below:
price at
the price at
beginning the end dividend
of last of last paid last
share year year year
A 80 90 8
B 150 120 5
C 40 42 4
D 200 215 20
470 467 37

14. Calculate total interest on loan. The principal of the loan is 10 000 and it will be
repaid in equal yearly instalments over 5 years. Interest rate is 10%.

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

15. Calculate future value of stream of instalments at the end of year 4. The values of
instalments for consecutive years are: 200, 100, 150, 150. Interest rate is 10%.
Then calculate FV again, however under the assumption that interest rates are
changing as follows: 8%, 9%, 9% i 10%.

16. You have to choose between 2 investment options: the first is offering nominally
14% p.a. with monthly compounding, while the second 14,5% with compounding
twice a year. Which one is better?

17. A principal was invested for 4 years. Nominal annual interest rates are expected
to be as follows: 13%, 12%, 11%, 10,5%. What is future value of the investment?
What are average geometric rate of return (a rate that assumes yearly
compounding) and logarithmic rate of return? What is holding period yield?

18. Choose between 3 options:


- bank deposit with 5% interest rate and monthly compounding for 6 months and
renewed once only
- bank deposit with 4,5% interest rate and constant compounding for 1 year
- an investment in stock of 10000 value and expected net profit of 1000.

19. What rate of return should be expected by an investor if he is considering stock


purchase with risk premium of 3% above annual effective interest rate on
government bonds? The bonds offer 5% and interest is paid 4 times a year, so
there is opportunity to reinvest.

20. Investor is managing a portfolio of stock. PV of portfolio is 1000. Investor is


managing his assets on a constant basis (few times a day) and average rate of
return is 4%. What will be the value of portfolio after 5 years?

21. A company has a loan account of 60 000 at the maximum. The usage of a loan
was as follows:
1.01.– 2 000
15.01. – 16 000
25.01. – 23 000
15.02 – repayment 30 000
04.03. – 20 000
31.03. – repayment of total value of debt
Assuming interest rate of 8% and 360 days/year basis calculate total interest.

22. Go to http://finance.yahoo.com/ . Download 3 selected companied historical


quotes for last 3 months and calculate daily rates on return: simple and
logarithmic. Then calculate average rates of return: assuming daily compounding
and continuous compounding.

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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.

23. Compare following investment, assuming yearly compounding of interest.

Present Future Time in


Investment Value Value years
A 1000 25000 10
B 20000 40000 3
C 5000 8000 1
D 3000 12000 7

24. Consider a situation that you have been given a choice of 3 investments. The sum
you want to invest is 10 000 EUR. Time period of your investment = 2 years.
The options are:
A saving deposit with annual compounding. Interest rate = 10 %.
A saving deposit compounded weekly with negotiable nominal interest rate.
A saving deposit with continuous compounding and negotiable nominal interest rate.
Due to the fact that you may negotiate your nominal interest rate in 2 and 3, try to
calculate what will be the interest rate making you indifferent between those 3
options. Is this rate may be used in your interest rate negotiations? Explain how?

25. Fill in the table with missing data:

Real Nominal
rate of rate of Inflation Inflation
return return rate Premium
12,00% 6,00%
1,85% 8,15%
5,15% -3,15%
-20,00% -16,00%
5,00% 7,00% 6,87%

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