This Lecture….

This lecture, we will consider project valuation methods in detail. More

specifically, we will quickly revise the NPV concepts first introduced in
FINM2001 Corporate Finance / FINM1001, before discussing other extensions to the NPV method of
project analysis. We will then compare this approach to other methods
FINM8003 Applied Corporate Finance of project valuation, including:
{ Other types of discounted cash flow analysis (“DCF”), namely:
z The internal rate of return (IRR); and,
z The benefit-cost ratio (or the profitability index).
{ The accounting rate of return;
Valuation Methods I { The payback period; and,
{ Certainty equivalents, a method which accounts for project risk by adjusting the
cash flows rather than the discount rate.

It is important to note that, throughout the course of this lecture, when we

compare projects, they will have the same lives. Methods of adjusting for
differences in lives, including methods not covered in FINM1001, will be
discussed during next lecture.

NPV Recap I NPV Recap II

Recall that, when considering an investment project using
NPV analysis, it is important to note the following:
{ We are only concerned with the incremental cash flows
associated with the project;
{ Consistency is important, meaning the cash flows and discount
rates should be estimated in a consistent manner. More
specifically:
z After-tax cash flows should be discounted using a tax-adjusted
discount rate;
z Nominal (inflation-adjusted) cash flows should be discounted using
a nominal (inflation-adjusted) discount rate;
z Risky cash flows should be discounted using a rate reflecting the
risk of the cash flows;
z If finance comes only from equity holders, the discount rate should
reflect the required rate of return for equity holders;
z If both debt and equity finance is employed, the discount rate should
reflect the cost of both sources of finance.
Also recall that cash flows are money physically paid or
received by the firm. The firm’s net cash flow in period t,
Ct, is defined as:
Ct = ( Rt − Et )(1 − τ ) + τ Dt − I t
Where:
Rt = Cash revenues generated by the firm in period t;
Et = Cash revenues paid by the firm in period t (NB: Does
NOT include depreciation);
Dt = Depreciation for period t; and,
τ = The tax rate; and,
It = Capital expenditure paid in period t;

NPV Recap III NPV Recap IV

Recall that the following 3 points should be noted in The net present value (NPV) of a project is
relation to the depreciation charge: the calculated as the present value of all
1. Sales tax, delivery charges and installation are
regarded as part of the cost of equipment and are future incremental cash flows produced by a
added to the cost of the asset for depreciation
purposes;
project less the initial cost of investment, C0,
2. If an asset is sold for a price greater than its and is calculated using the required return on
depreciated (or book) value, the excess is a taxable
gain. Conversely, if the asset is sold for a price less the project, k,or:
than the depreciated value, the difference is an
allowable deduction for tax purposes; and, C1 C2 C3 Cn
3. Costs associated with old equipment, including NPV = + + + ... + − C0
(1 + k ) (1 + k ) 2 (1 + k )3 (1 + k ) n
removal expenses, are not regarded as part of the cost n
of the new machinery and therefore are expensed Ct
immediately (ie at time 0). =∑ − C0
t =1 (1 + k )t
NPV Recap V
In determining whether to accept or
reject a particular project using NPV
analysis, we apply the NPV decision
rule. This rule can be summarized as
follows:
{Accept a project if its NPV>0;
{Reject a project if its NPV<0; and,
{Indifferent to a project if NPV=0.
New NPV Tools
Whilst FINM1001 provided a comprehensive
introduction to NPV analysis, there are a few
aspects that we didn’t cover in the interests of
simplicity, namely:
{How to account for tax in an imputation system;
{Different ways of calculating depreciation; and,
{The potential that projects will have working capital
requirements.
We will now consider each of these in turn, and
subsequently illustrate how they are accounted for
by way of an example.
Calculating Depreciation I
In FINM1001, we employed the straight line
method of calculating depreciation in light of
its simplicity. However, in reality, Australian
companies will employ either the prime cost
or diminishing value method to calculate
depreciation. We will now consider these
two methods in turn.
NPV Recap VI
Finally, recall that NPV figures calculated for projects with
different lives are not comparable and, therefore, we need to
restate the NPVs of the two alternatives in a way that will allow
direct comparison. We learnt in FINM1001 that one way to do
this is to compare the equivalent annual values (“EAV”) of the
two projects, calculated as below, and the decision rule is to
accept the project with the highest EAV (NB: In FINM1001, we
called this the annual equivalent approach, however, to ensure
consistency with the FINM2001 textbook, we will herein refer
to it as EAV).
NPV
EAV =
1 − (1 + k ) − n 
 k 
 
Post-Tax Cash Flows with Imputation
In FINM1001, whilst we assessed projects based on their after-tax cash
flows, we only took into account corporate tax (ie assumed a classical
tax system). However, we know in Australia the imputation system
exists and we need to take this into account in calculating post-tax cash
flows. Specifically, instead of calculating after corporate tax cash flows,
in a world where imputation exists, we will calculate after effective tax
cash flows, which are defined as:
Post-tax Cash flows = Pre-tax cash flows(1-te) + Dtte
Where te = tc(1-γ) and γ is the proportion of the tax collected from a
company that is paid out to shareholders and recovered through tax
credits associated with franked dividends. Further, given the
importance of consistency, we would use a post effective tax discount
rate in calculating the NPV of these cash flows, the calculation of which
we will consider in Lecture 8 (NB: In the interim, you will be given these
discount rates).
Calculating Depreciation II
Prime cost depreciation applies a constant rate (dp) to the asset’s
original cost, I0, to determine allowable annual depreciation. More
specifically, the depreciation deduction claimable at the end of year t, Dt
is calculated as:
Dt = d p * I 0
Note that:
{ Unlike with the straight line method, there is no inclusion of salvage value in
the depreciation calculation; and,
{ As with the straight line method of depreciation, any gain or loss on sale will
be calculated as the difference between the price the asset is sold for and
its book value (initial cost – accumulated depreciation). Further, gains are
taxable while losses are a tax deduction.
Calculating Depreciation III
Diminishing value depreciation applies a constant rate (dd) to the asset’s
beginning-of-year book value, and the depreciation for year t is calculated as:
Dt = d d * BVt −1
Where BVt-1 is the asset’s book value at the beginning of period t (the end of
year t - 1), which is equal to initial cost minus accumulated depreciation. Also
note that:
{ As with the prime cost method, no salvage value is included in the calculation.
{ As with both the straight line and prime cost methods of depreciation, any gain or
loss on sale will be calculated as the difference between the price the asset is
sold for and its book value (initial cost – accumulated depreciation). Further,
gains are taxable while losses are a tax deduction;
{ The depreciation costs will not be constant over the life of the asset;
{ It will be the maximum value in the first year and then decline in each successive
year; and,
{ This method will provide larger, earlier depreciation deductions.
Working Capital
The working capital effect is something resulting from the
fact that investment in long-term assets generally requires
the support of current assets. Further:
{ These current assets may be financed in part by non-interest-
bearing current liabilities;
{ Working capital is then equal to the difference between these
current assets and current liabilities; and,
{ An increase in working capital should be treated as a cash
outflow whenever it is required (e.g. at beginning of the
investment) and as an inflow whenever it is recovered (at end of
the investment).

Example I Example II
The use of different methods of calculating depreciation
and working capital is best evidenced by way of an Based on the preceding information:
example. Suppose Bettman Limited, which operates in a {Depreciation p.a. = $1 million * 7.5% = $75,000;
classical tax system, is considering the introduction of a {Post-tax net cash flows = $400,000(1-0.40) + $75,000 *
new project and has asked you whether they should 0.40 = $270,000 p.a.;
proceed. Information is as follows: {Calculate gain / loss on sale of equipment after 10
{ Initial cost of capital equipment is $1 million; years:
{ The equipment has an expected economic life of 10 years; z Book value of machine at end of life = $1,000,000 –
{ Annual net cash flows before tax are $400,000; $75,000 * 10 = $250,000;
{ The tax allowable depreciation rate is 7.5% prime cost; z Salvage value = $100,000; and,
z Therefore, loss on sale = $250,000 – $100,000 =
{ The working capital requirement is $200,000; $150,000.
{ Salvage value of equipment is $100,000;
{Tax deduction on loss on sale = 0.40 * $150,000 =
{ The post-tax required rate of return is 8% p.a.; and, $60,000
{ The tax rate is 40%.

Example III Other Methods of Project Evaluation

Given this information, the NPV of the project will be equal to
$778,471, as calculated below. Obviously, this means it should be
accepted: However, as mentioned at the start of the lecture,
NPV = Initial costs + Costs of working capital there exist other methods of project evaluation
+ PV (post-tax net cash flows)
+ PV (tax deduction on loss on sale) which we will now discuss in detail. These include:
+ PV (working capital recovery) {Other forms of DCF analysis, namely:
+ PV (salvage value)
z The internal rate of return (IRR); and,
1 − (1.08) −10  $60, 000 $200, 000 $100, 000
= −$1, 000, 000 − $200, 000 + $270, 000   + (1.08)10 + (1.08)10 + (1.08)10 z The benefit-cost ratio.
 0.08 
= $778, 471 {The payback period;
{The accounting rate of return;
In the event ABC Limited operated in an imputation tax system, the {Economic value added (EVA); and,
only difference would be that the cash flows and discount rate would
need to be calculated after effective tax, te, which is calculated as te = {Certainty equivalents.
tc(1-γ), rather than after corporate tax, tc.
Internal Rate of Return I Internal Rate of Return II
The internal rate of return (IRR) is the discount rate that The IRR is then compared to the required
will cause the present value of a project’
project’s future cash flows
to equal the initial outlay, or: rate of return, r, to decide whether a project
n
Ct
is acceptable as follows:
C0 = ∑
t =1 (1 + IRR )t {If IRR > r, the project is accepted;
In other words, the IRR is the discount rate that results in a {If IRR < r, the project is rejected;
project’
project’s NPV being to equal zero,
zero or: {If IRR = r, we are indifferent towards the
n
project.
Ct
0=∑ − C0
t =1 (1 + IRR )t

Internal Rate of Return III Internal Rate of Return IV

Consider an project where, by making an outlay of $120 today, a firm However, in some cases, a project will have multiple or
with a required rate of return of 10% would provide $20 at the end of indeterminate IRRs. Consider a situation where a project
each year for 7 years. Here, the IRR of 4% would be found by
solving the following equation using trial and error, a financial
involved an outflow of $100 at t=0, an inflow of $700 at t=1
calculator or something like SOLVER in the Microsoft Excel package. and an outflow of $1,200 at t=2. To find the IRR, we would
As IRR < r, the firm would reject the project : solve the following:
1 − (1 + IRR) −7  $700 $1, 200
0 = $20   − $120 0 = −$100 + −
 IRR  (1 + IRR) (1 + IRR ) 2

IRR = 0.04
= 4% This project has multiple IRRs, as discount rates of 2% and
3% will both make the NPV equal to zero.

Internal Rate of Return V Internal Rate of Return VI

Further, it is possible that a project has no IRR. Lastly, in the case of mutually exclusive projects,
Such a situation is when a project has an initial IRR can yield results that are at odds with those of
inflow of $100, an outflow of $200 at t=1 and an NPV (ie they give different ranking of projects).
inflow of $150 at t=2: This is a result of the fact that IRR fails to consider:
{The scale of investment; and,
$200 $150
0 = $100 − + {Differences in the timing and magnitude of cash flows.
(1 + IRR) (1 + IRR) 2

These two issues are illustrated in Examples 5.4

Put simply, there is no value of IRR that will cause and 5.5 in the textbook.
the NPV to equal zero.
The Benefit-Cost Ratio
The benefit-cost ratio, like both NPV and IRR, is a type of
discount cash flow analysis (“DCF”). More specifically, it is
an index calculated simply by dividing the present value of
the future net cash flows by the initial cash outlay, or:
Benefit-cost ratio =
Present value of net cash flows
Initial cash outlay
This ratio is then used to decide whether a project is
acceptable, with the following decision rule being applied:
{ Accept the project if its benefit–cost ratio > 1; and,
{ Reject the project if its benefit–cost ratio < 1.
The Payback Period I
The payback period is the period of time it takes
for a project to recoup the initial cash outlay from
the project’s after-tax net cash flows. Further:
{The payback period is then compared to a pre-
determined maximum acceptable payback period in
order to ascertain whether the project is attractive; and,
{The payback period is not usually used in isolation.
Instead, it is employed along with other discounted cash
flow methods of project evaluation.

The Payback Period II The Payback Period III

Advantages and weaknesses of the payback The following provides an illustration of how the
period approach to project valuation are as follows: payback period is calculated. In this instance, the
{Advantages: The payback period is simple to payback period is equal to (1+ 25/30) or 1.83
implement and provides an indication of how long a
firm will commit funds to a project. years :
{Disadvantages: The payback period approach does
not take into account the size and timing of the
project’s cashflows and does not provide guidance on
Period Cash Flow Balance Payback Cal.
what is an acceptable payback period. Further, it Initial cost -40 -40 0
ignores cash flows occurring after the payback period
and fails to account for project-specific risk. year 1 15 -25 1 year
year 2 30 5 (1+25/30) years

The Accounting Rate of Return Certainty-Equivalent Cash Flows I

Like the payback period approach, the accounting rate of return (ARR)
is usually used in conjunction with some type of DCF analysis, and is
calculated as follows: In most cases, risky projects are evaluated by
ARR =
Average after-tax profit using a cost of capital that reflects the risk of
Initial outlay or avg. book value or avg. investment
the project (ie a risk-adjusted required rate of
Once calculated, the accounting rate of return is compared to a
return). However, an alternative method of
predetermined required return to determine whether or not the project
should be accepted. Advantages and weaknesses of this approach to
project evaluation known as the certainty-
project evaluation are as follows: equivalent approach, accounts for risk by
{ Advantages: It is easy to calculate and, unlike the payback period
approach, takes into account all income associated with the project; adjusting the cash flows rather than the
and,
{ Weaknesses: The approach does not take the time value of money in to discount rate.
account and is based on accounting figures rather than cash flows.
Further, the approach does not account for project risk and does not
provide guidance regarding what constitutes a “good” accounting rate of
return.
Certainty-Equivalent Cash Flows II Certainty-Equivalent Cash Flows III
The certainty-equivalent net cash flow in year t, The NPV under the certainty-equivalent
Ct*, is the smallest certain cash flow that the firm approach is then calculated by discounting the
considering the project would be prepared to
accept in exchange for the expected risky cash certainty-equivalent net cash flow for each period
flow E (Ct ). Moreover, the expected net cash flow at the appropriate risk-free rate, or:
for year t can be converted to its certainty-
equivalent using the following: n
Ct*
Ct* = αt E (Ct ) NPV = C0 + ∑ (1 + R )
t =1 f
t

Where αt is defined as the certainty-equivalent

factor in Year t.

Certainty-Equivalent Cash Flows IV In Summary….

If all variables are correctly specified, the There are numerous methods that can be
present value of any future cash flow must be employed in assessing the viability of projects.
However, the NPV method is recommended for
the same under both the risk-adjusted discount investment evaluation as it is not only consistent
rate method or the certainty-equivalent method, with the goal of maximising shareholder wealth,
and therefore: but also has fewer problems than approaches
such as IRR.
E (Ct ) α t E (Ct )
=
(1 + k )t (1 + R f )t Further, in practice, other valuation methods such
(1 + R f )t as the accounting rate of return, payback period
∴α t = and economic value added are used in conjunction
(1 + k )t
with NPV.

Next Lecture….
Given the strength of NPV, we now focus on it and its use
in making complex investment decisions, covering:
{ The principles employed in estimating project cash flows;
{ How to choose between mutually exclusive projects with
different lives. In doing this, we will introduce new methods of
adjusting for life differences not considered in FINM1001,
namely the lowest common multiple method and the constant
chain of replacement in perpetuity method;
{ How to determine when to retire (abandon) or replace
equipment;
{ How to employ sensitivity analysis and break-even analysis to
analyze project risk; and,
{ The role of qualitative factors and resource constraints on project
selection.