Principles of Capital

Investment
RoadMap
Introduction
Ali Raza
Principles of Capital Investment
Administrative Framework
Investment Projects
CashFlows
Project Evaluation Techniques
Anam Jawaid
Average Rate of Return
Payback Period
Net Present Value
Internal Rate of Return
Profitability Index
NPV, IRR Comparisons
Shandana Nawaz
NPV Verses IRR
Compounding Rate Differences
Scale of investment
Capital Rationing
Capital Budgeting
Sara Syed
Capital Budgeting
Inflation
Biasness in Cashflows
Aquisitions
Introduction
When a firm makes capital investment,
it incurs a current cash outlay for the
benefit to be realized in the future.

Principles of Capital Investment
Introduction
Key Points
Most investment decisions involve outflows of cash, which result in
inflows of cash
Typically, an investment project involves a relatively large initial
investment (outflow of cash) at the beginning of the project
After the initial investment, a stream of cash inflows and outflows
spread over the project lifetime
Finally, provision may also have to be made for cash outflows
resulting from additional investments made over the project lifetime.
Large cash flows may also be required at the end of the project
lifetime
To evaluate the feasibility of investment projects investment.
Selecting which investment opportunities to pursue and which to
avoid is a vital matter to businesses
Focus is usually placed on evaluating expected cash outflows and resulting cash inflows in order to
determine if project is profitable
Administrative framework
Investment Projects

Classification
New products or expansion of existing product
Replacement of equipment or building
Research and development
Exploration
Others
Types
Replacement projects - Most assets have finite lifespan will have to be
replaced when existing assets reach end of lifespan
Expansion projects - Company wants to expand its current level of operations
by either internal or external expansion
Independent projects - Acceptance of project does not influence other
projects under consideration
Mutually exclusive projects - Implementation of one project results in rejection
of all other alternatives
Screening
Greater the capital outlay, greater the numbers of screen usually required.
Level and type of expenditure
Cash Flows
Cash flow Vs. Income Statement
Future re-investment
Stakeholders
Good managers Vs. Effective managers
Cash Flow Forecast
Initial cash flow
Operating cash flow
Terminal cash flow
Types of Cashflows
Depreciation
Interest on debt
Post tax cash flow
Working capital requirement
Incremental cash flows
Ignore sunk cost
Considerations
Compares initial cash investment to average
annual cash flow generated by project over its
lifetime
Return per Unit Investment
Average Rate of Return
100 *
Investment Initial
year per Return
Return of Rate Average =
100 *
Investment Initial
Return Average
Return of Rate Average =
Equal Return Every Year
Un-Equal Returns every year

O
O
O
Sizwe Limited is choosing between two investments.
Project A requires initial investment of R25 000;
Project B requires amount of R100 000. The relevant
annual cash inflows for each project are as follows:

Year Project A Project B
1
2
3
4
R5 000
R10 000
R15 000
R20 000
R60 000
R36 000
R30 000
R24 000

The AR for Project A can be determined as follows:

AR
Project A
=
100 x
C
4 / C
0
4
1 t
t
|
.
|

\
|

=

=
( )
100 x
000 25
4 / 000 0 2 000 15 000 10 000 5 + + +

= 50%
Example
Pros & Cons
Simple
Shows result in
percentage
Time value of money
ignored
Based on accounting
income instead of
cashflows
Benefits in last year are
valued the same as first
year

Average Rate of Return
Number of years required to recover our initial cash
investment

cashflow annual
investment initial
Period Payback =
Payback Period
DPB calculates expected number of years required
to recover initial investment by considering
discounted net cash flows
Calculated based on cash flows that are
discounted at companys cost of capital
Discounted Payback Period
Normal Payback Period
You are required to calculate the DPB for Project A if:
Cost of Capital = 10%.
Initial Investment = Rs. 25,000
Year
Cash flow
1
2
3
4
5,000
10,000
15,000
20,000
Accumulated cash flows after 2 years:
5,000 + 10,000 = Rs.15,000

Only Rs10,000 of Year 3s cash flow required to recover initial
investment.

years DBA
000 , 15
000 , 10
2 A Proj ect + =



= 2.67 years
Example (Payback Period)
Pros & Cons
Simple
Tells breakeven
point

No time value of
money
Fails to consider
cashflows after
payback period
Doesnt measure
profitability
Payback Period
You are required to calculate the DPB for Project A if:
Cost of Capital = 10%.
Initial Investment = Rs. 25,000
Year Project A
Cash flow Cash flow
discounted at
10%
1
2
3
4
5,000
10,000
15,000
20,000
4,545.45
8,264.46
11,269.72
13,660.27
Accumulated discounted cash flows after 3 years:
4,545.45 + 8,264.64 + 11,269.72 = Rs.24,079.63

Only Rs.920.37 of Year 4s discounted cash flow required to recover
initial investment.

years DBA
13,660.27
920.37
3 A Proj ect + =



= 3.07 years
Example (Discounted Payback Period)
Difference between present value (PV) of all
expected net cash inflows and PV of all
expected net cash outflows calculated over
expected life of project
With NPV method: net cash flows are
discounted at cost of capital (i) to determine
their PV, and compared with initial
investment
NPV = PV of expected cash flows initial investment
=
( )

=

+
n
1 t
0
t
t
C
i 1
C

Net Present Value
You are required to calculate the NPV for Project A if:
Cost of Capital = 10%
Initial Investment = Rs. 25,000
Year Cashflow
1
2
3
4
5,000
10,000
15,000
20,000
NPV
Project A
=
( )

=

+
n
1
0
C
1
C
t
t
t
i

=
( ) ( ) ( ) ( )
000 25
1,10
000 20
1,10
000 15
1,10
000 10
1,10
000 5
4 3 2 1
+ + +

=
000 25
1,4641
000 20
1,331
000 15
1,21
000 10
1,10
000 5
+ + +

= 4,545.46 + 8,264.46 + 11,269.72 + 13,660.27 25,000
= Rs 12,739.91
Example
Pros & Cons
Caters mutually
exclusive projects
Compounded at
required rate of return
as the discount rate
Scale of investment
(expressed in
absolute terms)
Requires knowledge
of cost of capital
Sensitivity to discount
rates
Net Present Value
Discount rate that equates PV of expected
net cash inflows and PV of net cash
outflows
Net Cash Outflows = Net Cash Inflows
Discount rate that will result in
NPV = 0

( )
( )
0
0
C
IRR 1
C
0 C -
IRR 1
C
n
1 t
t
t
n
1 t
t
t
=
+
=
+

=
=

Internal Rate of Return
You are required to calculate the IRR for Project A.
Suppose that the cost of capital = 10%.

Based on the use of a financial calculator, the IRR
is determined as follows:

Input Function
25 000 Cf
0

5 000 Cf
1

10 000 Cf
2
15 000 Cf
3

20 000 Cf
4


IRR = 27.27%

Example
Pros & Cons
Simple
Percentage return is easy to
comprehend
Doesnt cater changing cash
flows
Considers rate of earnings
not size of earnings
Only with independent
projects
Funds are compounded at
IRR
Scale of investment
(expressed as %age)
Multiple IRRs
Internal Rate of Return
MIRR: Attempts to improve on IRR method
O Include more conservative view on
reinvestment rate earned on cash flows
generated during projects lifespan.
Also solves problem with multiple IRR
values
O Cash stream converted into only cash inflow
and cash outflow value
PV Cash outflows =
( )
n
MIRR 1
inflows cash of FV
+

Modified IRR
Future values of the cash inflows for Project A

Year Project A
Cash flow Cash flow
accumulated
at 10%
1
2
3
4
R 5 000
R10 000
R15 000
R20 000
R 6 655.00
R12 100.00
R16 500.00
R20 000.00
R55 255.00

MIRR Project A is calculated by solving following equation:

PV Cash inflows =
( )
n
MIRR 1
outflows cash of FV
+


-25 000 =
( )
4
MIRR 1
255 55
+


Solving equation yields MIRR
ProjectA
= 21.93%.
Example
Benefit-Cost Ratio
PV of net future cashflows over the initial
cash outlay

investment Initial
flows cash future of PV
PI =


Therefore, PI can be calculated by:


( )
0
n
1 t
t
t
C
i 1
C
PI

=
+
=

Profitability Index
Calculate PI of Project A.
Cost of capital = 10%

Year Project A
Cash flow Cash flow
discounted
at 10%
1
2
3
4
R 5 000
R10 000
R15 000
R20 000
R 4,545.45
R 8,264.46
R11,269.72
R13,660.27
R37,739.91


investment Initial
flows cash future of PV
PI =


25,000
37,739.91
=

= 1.51
Example
Comparisons
ROI Factor Value Comments
NPV
> 0 (Positive) Acceptable
0 (Zero) May or may not be acceptable
< 0 (Negative) Reject
IRR
> Required Rate Acceptable
< Required Rate Reject
Payback
Period
> Acceptable
Period
Invest in a project with small
payback period
< Acceptable
Period
Reject
Profitability
Index
> 1 Or 1 Accept
< 1 Reject
Caters mutually
exclusive projects
Compounded at
required rate of
return as the
discount rate
Scale of investment
(expressed in
absolute terms)
Only with
independent projects
Funds are
compounded at IRR
Scale of investment
(expressed as %age)
Multiple IRRs
N
e
t

P
r
e
s
e
n
t

V
a
l
u
e

I
n
t
e
r
n
a
l

R
a
t
e

o
f

R
e
t
u
r
n

NPV Versus IRR
O Contradictory results in mutually exclusive projects
O Contradiction is due to the difference in the implicit
compounding of interest.

O Multiple IRRs are possible.
O How to overcome this issue?

Compounding Rate Differences
Multiple Rate of Return
NPV Versus IRR
Capital Rationing
Rationing
Rationing is basically a process of controlled distribution of
resources
Capital Rationing
It occurs any time there is budget ceiling or constraint on the
amount of funds that can be invested during specific period of
time.
What happens when the capital is rationed?
It can also be understood as taking example of a company that
is allowed to make capital expenditures up to specific budgeted
ceiling. Where division has no control.
Its purpose is to select the combination of investment
proposals offering greatest profitability.
You do not invest in all proposals increasing the NPV but you
accept the proposal within your budgeted amount.
O Its objective is to select a combination of
investment proposals offering highest NPV
keeping in view the allocated budget.
O Cost of the certain investment projects may
spread over several years.

O Budget ceiling carries its cost too.
O Capital rationing results in an investment policy
that is less than optimal

Selection Criteria
Problems
Capital budgeting (or investment appraisal) is the
planning process used to determine whether an
organization's long term investments such as new
machinery, replacement machinery, new plants,
new products, and research development projects
are worth pursuing. It is budget for major capital, or
investment, expenditures.

Capital Budgeting
O In practice, an inflationary economy distorts capital budgeting
decisions
O As income grows with the inflation, an increasing portion is
taxed with the result that real cash flows do not keep up with
inflation
O Without inflation, depreciation charges represent the cost of
replacing the investment.
O The presence of inflation results in lower real rates of return
and less incentives for companies to undertake capital
investments.

Inflation
Definition
Inflation is the increase in the general level of prices for all
goods and services in an economy.
Effects
O In estimating cash flows, it is important that the
individual company take anticipated inflation into
account.
O Future inflation does not affect depreciation
charges on existing assets.
O The effect of anticipated inflation varies with cash
inflows and outflows.
O If a nominal required return is used, nominal cash
flows (inflation adjusted) should be employed.

Biasness in Cashflows

O It is earning before interest, tax, depreciation and
amortization.
O From the EBITDA estimates, we subtract three things:
O Expected taxes to be paid
O Likely future capital expenditures
O Expected net additions to working capital.
O In the case of an acquisition investment, the life of the
project is indefinite.

Analysing Acquisition
Measuring Free Cashflows
EBITDA

O Free cash flows are what remain after all necessary
expenditures and they determine an acquisition value.
O In evaluating the prospective acquisition, the buying
company should estimate the future cash income that the
acquisition is expected to add.

O What would be the acquisition other than the
cash???
O Sometimes, the buyer assumes the liabilities of
the company it acquires.
O If securities other than cash are used in the
acquisition, they should be converted to their
cash equivalent market values.

Non Cash Payments And
Liability Assumptions