Finance567;Assignment2bySanjeevSabhlok;24.5.

93
INVESTMENTAPPRAISALDECISION
1.INTRODUCTION
Theinvestmentdecisionisperhapsthemostimportant
financialdecisionforafirm,asindicatedby Brealeyand
Myers'ThirdLaw:"There'smorevaluetobegainedbygood
investment decisions than by good financing decisions
(Brealey,1988:451)". The investment decision, also called
capitalbudgetingdecision,isadecisionofhowmuchnotto
consumenowsothatmorecanbeconsumedinthefuture.This
couldbedoneeitherbylendingorbyproducing,withthe
expectation of getting returns at least equal to the
market'srateofreturn.
Now, for the sake of theoretical tractability, it is
assumed for most of this paper that capital markets are
perfect and complete and that there are no imperfections,
including taxes. In such a situation, there would be no
reasonforanyprojecttogiveapositivenetreturn.Ina
perfectlycompetitivemarket,whereallopportunitieshave
been duly exploited, there would exist no potential for
returnshigherthanthemarketrateofreturn.Onlywhena
firmiscompetitiveinaparticularareaforsomeparticular
reason will it be possible to have a project with net
positive returns. Thus positive NPVs come from specific
competitiveness.Itisassumedintherestofthediscussion
thatthefirmdoeshaveacompetitiveedgewhichcouldlead
toreturnshigherthanthemarketrateofreturn.Weshall
alsoconsiderthefinancinganddividenddecisionsasgiven.
Further,inperfectcapitalmarkets,theFisherseparation
principleallowstheconsumptionandinvestmentdecisionsto
beconsideredindependentlysothatthedecisioncriterion
forshareholderswouldbeto"maximisethepresentvalueof
lifetimeconsumption"(Copeland,1983:18).Asweareaware,
in reality there could be other interests operating, and
agency costs to be incurred. Hence "a best technique for
rating investment projects is heavily dependent on the
decisionmaker'sobjective"(BogueandRoll,1974:601).But
in this paper, we assume that agency costs are absent
(Copeland,1983:20).

How much to invest today, is referred to as the

capitalwidening decisionandhowlongtoinvestitforis
thecapitaldeepeningdecision(Martin,1988:111).Thereare
three types of investment decisions: (i) the usual
investment decision, or the allocation of capital to
investment proposals, (ii) the decision to reallocate
capital, when an existing asset no longer justifies
continuedcommitmentofcapital,and(iii)acquisitionsand
mergers,whicharesimilartootherinvestmentdecisionsin
manyways.
2.THEDECISIONCRITERIA
Selectingthecorrecttechniqueforinvestmentpurposes
isveryimportant."Theuseofanimpropercapitalbudgeting
technique will result in aggregate errors which stock
holders will not be able to eliminate" (Bogue and Roll,
1974).Thedecisioncriterionforcapitalbudgetingpurposes
shouldtakeintoaccountallcashflows;thesecashflows
shouldbediscountedattheopportunitycostoffunds;the
technique should be capable of selecting from a set of
mutually exclusive projects; and finally, the value
additivityprincipleshouldhold(Copeland,1983:26).

2a)

Traditionaltechniques: Sophisticated, or discounted

cashflow(DCF)techniques,takeintoaccountthetimevalue
ofmoney.Thesearethenetpresentvalue(NPV),internal
rate of return (IRR) and profitability index (PI) or
benefitcost ratio. The MIRR (modified internal rate of
return) is also used (Brigham,1990:282). There are also
numerousunsophisticatedtechniques,chiefamongthesebeing
the payback method, including discounted payback, and the
averagerateofreturn(ARR)onbookvalue.Whilewedonot
deliberateontheunsophisticatedtechniqueshere,andwhile
it will shortly be seen that the NPV is the "best"
technique, it would not do to outright reject the use of
othertechniques."Thedifferentmeasuresprovidedifferent
typesofinformationtodecisionmakers,andsinceitisso
easytogeneratethevaluesforthemeasures,allshouldbe
considered in the decision process. For any specific
decision, more weight might be given to one measure than
another,butitwouldbefoolishtoignoretheinformation
inherentinanyofthemethods"(Brigham,1990:289).
The correct sophisticated (DCF) technique: Initially, the
IRRwasthemethodrecommendedtofirmsbytheoristssuchas

Dean (1951). But in the mid and late 1950s, it was

conclusivelyshownbySavage(1955)andHirshleifer(1958)
that NPV is the superior technique and that the IRR rule
oftenbreaksdown.TheIRRrulegivesrisetothefollowing
problems:
a)

b)

c)

d)

e)

f)

Changeinsignofcashflows(lendingorborrowing):If
a project offers positive cash flows (borrowing)
followedbynegativeflows(lending),thentheIRRrule
breaksdown(Brealey,1988:80).
Morethanonechangeinsignofcashflows(multiple
roots,orratesofreturn):Ifthereismorethanone
changeinthesignofthecashflows,theprojectmay
haveseveralIRRs,ornoIRRatall(e.g.theoilwell
pumpproblem).ItmustbementionedherethattheMIRR
has overcome the multiple IRR problem (Brigham,1990:
283).
Mutuallyexclusiveprojects:TheIRRruleoftengives
thewrongrankingofmutuallyexclusiveprojectswhich
differineconomiclifeorinthescaleofinvestment.
Termstructureofinterestrates:TheIRRrulerequires
acomparisonoftheproject'sIRRwiththeopportunity
costofcapital.Butoftentheshortrunandlongrun
opportunitycostsdiffer.Itthenbecomesdifficultto
determineayardstickforevaluatingIRR.
Reinvestment at the IRR (implicit reinvestment rate
assumption).Itisassumedthatthetimevalueofmoney
istheIRR,i.e.,investorscanreinvesttheirmoneyat
the IRR for each project. But reinvestment should be
considered only at the opportunity cost of capital.
HencethisassumptionundertheIRRruledefieslogic
(Copeland,1983:32).
Combinations of mutually exclusive and independent
projects: The IRR rule violates the value additivity
principlewhencombinationsofmutuallyexclusiveand
independentprojectsaretaken(Copeland,1983:32).

In view of the above, NPV is treated as the correct

decisioncriterionforDCFanalysisinthispaper.

2b)

Strategicanalysis: Manyprojectsmaygiverisetoreal
options, and require a strategic analysis. The DCF
techniques are inaccurate in capturing the range of
possibilities in such cases. For example, businesses with

substantialgrowthopportunitiesorintangibleassetshave
optionsontheirinvestments(Myers,1984:135).
3.CASHFLOWS
Two variables determine the NPV: the expected future
cashflows andthe expectedopportunitycost.Attheheart
oftheNPVarethecashflows.Ifthesearebiased,thenthe
NPVrulewillfail(Brealey,1988:88).Acashflowissimply
thedifferencebetweencashreceivedandcashpaidout.We
areinterestedhereintheaftertaxcashflowsforanall
equityfirm,buttheprinciplesholdtrueevenforafirm
usingleverage(Weston,1989:104).
3A Certain cash flows: Let the cash flows be known with
certaintyandassumethattheseflowsareperpetual,i.e.,
there is no growth (Copeland,1983:37). Then the relevant
(certain)cashflowsaregivenby

CF= (_R_VC_FCC)(1c)+c(_dep)_I,
where,CFstandsforcashflowsforcapitalbudgeting,
_R represents revenues, _VC is variable costs of
operations, _FCC is fixed cash costs, c is the
corporatetaxrate,_depisdepreciation,and_Iisthe
investment.
Itistobenotedthatalladditional,associated,cash
flows that follow from project acceptance have to be
included (incremental cash flows). Allocated accounting
overheads are included if they result from an actual
increasecausedduetotheproject.Sunkcostsareignored.
3BUncertaincashflows: Inthecaseofuncertaintyabout
futurecashflows,thesameformulaasaboveapplies.But
what we get are forecasts of cash flows (usually the
expectedcashflows).Veryoften,theforecasterrorsare
quite large (Brigham,1990:298). The way out is to ensure
thatallpersonsinvolvedinforecastinguseacommonand
consistentsetofmacroeconomicandotherassumptions.Data
on probability distributions of the estimates, and their
standard errors is essential. Fortunately, most of the
forecasterrorsarerandom(unbiased)andcanbeexpectedto
cancelout.Ontheotherhand,somestudieshaveshownthat

cashflowforecastsarenotunbiased,butarecommonlyover
optimistic (Brigham,1990:316). This consistent upward
estimationofforecastshastobetackledcarefully.Oneway
beingadoptedbyfirmsistokeeptrackofthehistorically
determined overestimates, if any, made by different
managers, and to include this information in their future
forecasts. The second method is to ask from where do the
positive net present values come from? What is the
competitive advantage of the firm in that project?
Additionalpointsrequiredtobeconsideredare:
i)
ii)

ii)

Thecrosssectionalrelationshipsbetweencashflows.
Correlationsofcashflowsovertime:ifthecashflows
of year t are dependent on cash flows for year t1,
then the variance of the project cash flows becomes
largerandtheprojectriskier.
Links between today's investments and tomorrow's
opportunities have to be worked out. Tomorrow's
opportunities often represent an option, and require
separateanalysis.
Fromtheforecastswegeteitherof:

a)

b)

Expectedcashflows,orE(CF): Inthiscase,riskis
taken into account by adjusting the discount rate
(riskadjustedreturn,orRADR).
Certainty equivalent cash flows or, CE(CF): In this
case, risk is absorbed into the cash flows. It was
shown by Rubinstein (1973), using the CAPM, that if
isthemarketpriceofrisk,i.e.,
=E(Rm)Rf
VAR(Rm)
whereE(Rm)istheexpectedmarketrateofreturn,
Rf isthemarket'sriskfreerateofreturn,and
VAR(Rm)isthevarianceofRm.
then,theCE(CF),orcertaintyequivalentcashflowis:
CE(CF)=E(CF)COV(CF,Rm)

where COV(CF,Rm) is the covariance of the

cash flow with the market rate of return
(Copeland,1983:196).
Both versions of the cash flow lead to equivalent
resultsintheoneperiodcase(Copeland,1983:195).Butin
themultiperiodcase,RobichekandMyers(1966)showedthat
the CE technique is superior to the E(CR) and RADR
technique. According to them, risk and time are logically
distinct variables. The CE approach takes account of them
separately,buttheRADRapproachlumpsthemtogether.The
onlyproblemisthat"thereisnopracticalwaytoestimate
a risky cash flow's certainty equivalent. Each individual
would have his or her own estimate, and these could vary
significantly."(Brigham,1990:368).ThereforetheCEmethod
isnotcommonlyused.WemustnotethatifweusetheCE
methodthentheriskfreerateisusedtodeterminetheNPV.
4.DISCOUNTRATE
Thecostofcapitaldependsontheusetowhichitis
put (Brealey,1988:173). Therefore, the required rate of
returnonaprojectwilldependontheriskinessofitscash
flows.
4A. CERTAIN CASH FLOWS: The following analysis holds when
eitherthecashflowsareknownwithcertainty,orwehave
CE(CF).Inthesecasesthereisnofurtherriskinessofcash
flowsandRf isusedtodiscountthesecashflows.Butwe
musttakenoteofthefollowingtheoreticalaspects.

4A.1

Twoperiodcase:
a)

Lendingandborrowingratesarethesame(equaltor):
Let an individual have an endowment of (y0,y1) of
incomesatthebeginningandendoftheperiod,anda
seriesofutilitycurvesU.Then,ifonlyproductionis
anopportunitytohim,thenhewillconsumeanamount
C0whichisexactlyequaltotheamountheproducesin
thefirstperiod,P0,andinvesty0C0,suchthatthe
marginal rate of substitution of his consumption is
exactlyequaltothemarginalrateoftransformationof
his production opportunity set. If borrowing and

lendingisallowed(capitalmarketsexist),thenitcan
be shown that the individual can increase present
consumption C0 and thus increase his utility, by
borrowingdownthemarketlineattheinterestrater
(Copeland, 1983: 11). "A very practical example is
building a house and then borrowing on it through a
mortgagesoastoreplenishcurrentconsumptionincome"
(Hirshleifer,1958).Theimportantthinginthisprocess
is that MRS = MRT = (1+r), where r is the lending/
borrowingrate.Thisholdstrueforallinvestors.This
process was demonstrated by Hirshleifer (1958). The
Fisherseparationtheoremarisesfromthis:ifcapital
marketsareperfectandcomplete,thenallindividuals
will reach the same decision for wealth maximisation
with reference to the market rate of return. In
practice,itisassumedthattheriskfreemarketrate
ofreturn,Rf,cansufficientlyrepresentr.
(b)

Borrowing rate greater than lending rate: When the

capitalmarketsarenotperfect(therearetransaction
costs),thenborrowingandlendingrateswilldiffer.
In this case the solution becomes more complicated,
withthreezonesbeingcreated.Hirshleifershowedthat
inZoneI,theborrowingrateistherelevantrate,in
ZoneIIIthelendingrateisrelevant,andinZoneII,
aratesomewherebetweenthesetworatesisrelevant.
TheFishertheorembreaksdowninsuchacase,andthe
subjectivepreferencesofindividualsenterbackinto
the picture. Thus, the complications introduced by
transactioncostsaredifficulttoquantify.Rfisused
inthiscasetoo,asaconvenientproxy,butwemust
rememberthatitmaynotbethecorrectdiscountrate,
and the subjective utility functions of shareholders
havetobeconsideredtoo(ifthatispossible).

4A.2Multiperiodcase: Hirshleifer(1958)alsoshowedthat
essentiallyitispossibletogeneralisetheprinciplesof
investmentanalysisofatwoperiodcasetothemultiperiod
case,withthemarketlinebecomingahyperplane,andthe
indifferencecurvesbecomingindifferenceshells.
4B. UNCERTAIN CASH FLOWS: The determination of RADR is
necessarywhenweusethemeancashflowsE(CF).Theeffect
of risk on the required rate of return (RRR) has to be

considered.Aprojectcanhavethreekindsofrisk:stand
alone risk, withinfirm (corporate) risk, and market risk
(Brigham,1990:341).Aninvestorisusuallyinterestedonly
inthemarket(systematic)risk,whichistherelativerisk
of the project with reference to the market, since
unsystematicriskcanbediversifiedawaybytheinvestors
on the capital market. But when liquidation costs exist,
then unsystematic, corporate, or total risk, is also
relevant to the shareholders since diversification can
preventthepossibilityofbankruptcy(Brigham,1990:376).
TheWACC(weightedaveragecostofcapital)isauseful
startingpointforestimatingtheappropriatediscountrate.
But the problem is that WACC considers the risk of the
firm'sexistingprojects,andnotspecificallythatofthe
projectunderconsideration.TheWACChastobeadjustedfor
riskbyconsideringtheproject'sriskcategoryinrelation
to the divisional/ company risk structure. Unfortunately,
this is a subjective adjustment, and not theoretically
sound.Thecorrectwaywouldbetodeterminetheproject's
systematic risk or proj, and then apply the CAPM to
determinetheRRR.Theoretically,itwouldbepossibletodo
even better, by applying the APM. We look into these two
methodsbelow.WealsotouchupontheAPVtechnique.
4B.1 Arbitragepricingmodel,ortheory(APM/APT): Inthe
APT,formulatedin1976byRoss,theassumptionmadeisthat
theRRRonanysecurityisalinearfunctionofthemovement
of a set of fundamental factors, which are common to all
securities.ThereturnRonanassetwouldbegivenbythe
followingequation,whenthreefactorsareconsidered:
R

E(R)+1F1+GNPFGNP+rFr+_

whereF1,FGNPandFrrepresentsystematicriskbecause
these factors affect many securities. The term _ is
considered unsystematic risk because it is unique to
eachindividualsecurity(Ross,1990:311).
Thekfactormodelwouldreadas:
Ri=

E(Ri)+bi1F1+...+bikFk+_i

where Ri is the random rate of return on the ith

asset,E(Ri)istheexpectedrateofreturnontheith
asset,bikisthesensitivityoftheithasset'sreturn
to the kth factor, Fk is the mean zero kth factor
common to the returns of all assets under
consideration,and_iisarandomzeromeannoiseterm
fortheithasset(Copeland,1983:211).
TheAPTallowstheconsiderationofalargenumberof
fundamentalfactorswhichisnotpossibleintheCAPM(Ross,
1990:453). Chen, Roll and Ross (1983) find industrial
production,inflation,interestratetermstructure,andthe
spread between low and high grade bonds to be important
economicvariables(Bower,1986).ThepredictivepowerofAPM
has been found to be superior to the CAPM in all tests.
However, there is disagreement on the variables involved,
and there are many complications in applying the APM.
ThereforetheAPMisnotcommonlyusedfordeterminingRADR.
4B.2 Capital asset pricing model, or CAPM: In case the
marketrateofreturnisconsideredtobetheonlyrelevant
factor,thentheAPTleadsustotheCAPM,whichcanthenbe
consideredasaspecialcaseoftheAPM.Accordingtothe
CAPM,sensitivitytoasinglemarketindex doesasgooda
job as any multifactor model since the different
sensitivities of the asset to the collection of economic
forces"netout."
4B.2.1Singleperiodcase:
4B.2.1.1Allequitycase:Inthiscase,theprojectaswell
as the firm are financed entirely by equity. The CAPM
assumesperfectcapitalmarkets,welldiversifiedinvestors
andhomogeneousexpectationsandthereforeworkswellunder
a"singleperioduncertainty"case,asshownbyRubinstein
(1973).TheCAPMrequirestheprojecttoearnatleastthe
rate of return required by the market on projects of
equivalent risk (Weston,1989:437). Rubinstein considered
that the new asset already exists and is valued in the
market(Martin,1988:292).HethenshowedthattheRADRis
givenby:
E(Rproj)=Rf+[E(Rm)Rf]proj.

where,Rproj istheRADRontheproject,and proj is

theproject'sbeta(Weston,1989:441).
Projectswithgreatersystematicriskwillhavegreater
betas,andtheirRADRwillbehigher.Here,weseethatR f
and Rm are generally known, but the problem is the
determinationofproj,whichwenowlookinto,below.
a)

When the project has the same risk as the company's

existingassets, thenthecompany'sbetaofassetsis
required.Itisdeterminedbyregressinganaccounting
measureofreturnforthecompany(suchasthereturn
onassets)onaneconomywideindexofreturns(suchas
the average return on assets for nonfinancial
corporations).Therearecomplicationsassociatedwith
thisapproach,whichwedonottouchuponhere.

b)

When the project has different risk to that of the

company thenitistheassetbetaoftheprojectthat
counts. Since product markets do not have active
secondary markets, finding proj from historical
informationisnotusuallyfeasible(Rao,1992:366).The
techniquesusedthereforeare(Brigham,1990:363):
i)
Inthepureplaymethod,existingfirmsproducing
a single product similar to the project under
considerationaresoughtout.Thebetasofthesefirms
are determined through regression analysis, and can
thenbeusedasaproxyforproj.
ii) When such singleproduct, publicly traded firms
suitableforthepureplayapproacharenotavailable,
then accounting beta method is used. Here a suitable
proxyischosen,suchasthedivisionofanotherfirm,
oraprivatelyheldfirmwhichmatchestheproject,and
a time series regression of that division's earning
power is run against the average earning power of a
largesampleofstocks(Brigham,1990:364).Wenotethat
accountingbetasarenotasgoodasmarketbetas.

4B.2.1.1.2Whenthefirmhasleverage: Ifthefirmaswell
astheprojectincludedebtfinancing,then asacompany

increases its degree of debt financing, the investors

require an additional financial risk premium. The RADR is
thenadjustedundertheCAPMbytheHamada(1969)formulain
casetheclassicaltaxsystemapplies.HeretheRADR,keL
(thecostofequitytoaleveragedfirm)isthesumofrisk
freerate,businessriskpremiumandfinancialriskpremium.
keL=Rf+(RmRf)U+(RmRf)L
whereListhebetaoftheleveredfirmandUisthe
betaoftheunleveredfirm.Butweknowthat
L=U[1+(B/S)(1T)

(Hamadaformula)

whereBisthemarketvalueofdebt,Sisthevalueof
sharesoftheleveredfirm,andTisthecorporatetax
rate.Therefore,
keL=Rf+(RmRf)U+(RmRf)U(1T)(B/S)
In Australia, where the dividend imputation system
prevails, if there is no earnings retention and no
preferential treatment of capital gains, and if a
comprehensivemeasureofincomeisused,thentheCAPMtakes
the form which would apply if there were no taxes (Van
Horne,1990:257):
keL=Rf+(RmRf)U+(RmRf)U.B/S
or

keL=Rf+(RmRf)U(1+B/S)

4B.2.1.1.3 Liquidation costs (Total risk to the firm):

Projectsfinancedwithdebtcouldattimescauseanimpact
onthetotalrisktothefirm(corporaterisk),bybringing
about the possibility of bankruptcy. The diversification
aspects of a proposed investment are relevant to its
evaluation in such a case (Van Horne,1990:243). A project
whichhasadiversificationeffectwouldhavealowerRADR,
at least from the point of view of the shareholders/
debtholdersandperhapsthemanagement.Thisdiversification
effect could be verified by correlating the project's
cashflows/NPVwiththerestofthefirm'sprojects.


4B.2.2

Multiple period case: We know that the CAPM

relates to a single period only; but investment analysis
almost always considers more than one year/ period. Many
problemsarisewhentheCAPMisextendedtomorethanone
period.ThefutureRf,Rm,andevenproj varyovertime.
Someprojectsaresaferinyouththaninoldage,othersare
riskier.Inparticular,theextensionofCAPMissaferwhen
proj remains constant over time, than if it changes
significantly.Inthelatterinstance,itwouldbenecessary
toapplydifferentbetas(andconsequently,differentRADRs)
over different future periods. Unfortunately, there is no
practicalmethodtoestimatethesechanges,andtheerrors
inestimatescanincreaseovertime.HencewhentheCAPMis
extendedtothemultiperiodcase,wemustrealisethatits
powerdeclinesovertime(Rao,1992:373).
Infact,BogueandRoll(1974)showedthatmultiperiod
capital budgeting is simply not possible if there are
imperfectmarketsforphysicalcapital.Theyalsorequired
theconsideration,notonlyofthesystematicriskinthe
usualCAPMsense,butalsooftheriskoffluctuationsin
the riskfree rate and the covariation risk of the
intermediatevalueoftheproject(Copeland,1983:363).Fama
(1977)reexaminedBogueandRoll'scritiqueandfoundthat
certain uncertainties allowed by Bogue and Roll are
inadmissibleinthestationaryCAPMcontext,whichassumes
theportfolioopportunitysettobenonstochastic.Therefore
theonlyadmissibleformofuncertaintyisintheexpected
cashflowsattimet,assessedattime<t.TheRADRineach
futuretimeperiodcannotbeuncertainiftheassumptionsof
theCAPMhold. Hethereforeshowedthatgivenitsstrong
assumptions, the CAPM does allow extension to the
multiperiod (Copeland,1983:363). Finally, Constantinides
(1980)hasbeenabletoshowthemultiperiodextensionof
CAPMtobevalidunderalessrestrictivesetofassumptions
(Copeland,1983:364).Buthe notedthatapplicationofthe
CAPM becomes very complex in such a case. The only
exception is a case in which the effect of the
nonstationarityinthemodel'sparametersthroughtimeisof
littlepracticalsignificance(Martin,1988:312).
In brief, we note that there are considerable
difficultiesinvolvedinextendingCAPMtothemultiperiod

case. Inspite of this, it is still used as a useful

approximation.
4B.3 Adjusted NPV approach (APV): Myers has proposed an
alternative adjustment process in case of a levered firm.
Here,theproject's"basevalue"isestimatedbyconsidering
ittobeanallequityminifirm.TothisisaddedtheNPV
of the sideeffects caused by project acceptance. This is
fundamentallyageneralisationoftheWACCrule.Here,
n
n
APV=OCFt

+kdBT
t=0(1+keL)t
t=0 (1+kd)t
where OCFt is the aftertax operating cash flow in
periodt,kdisthecostofdebtfinancing.
Projects which have a positive APV are considered as
having an adjusted cost of capital r*. This r* can be
approximated by the MM or the Miles and Ezzell formulae
(Brealey,1988:449).However,theadjustedcostofcapitalis
notcommonlyusedtodeterminetheRADRforaproject.
5.NPVUNDERCERTAINTY
Havingdeterminedtheitscashflowsanddiscountrate,
the next step for the firm is to determine the NPV. The
usual approach is valid for one or more independent
projects,wherethemanagercanchoosetoundertakeanyor
allofthem(Copeland,1983:26).Here,projectswithpositive
NPVsareaccepted;orifnecessary,thosewiththehighest
NPVsareselected.Butforinteractingprojects,additional
issues have to be borne in mind. Contingent projects are
thosewhichhavetobecarriedouttogetherornotatall.
These include mutually inclusive projects, where the
acceptability of one project is contingent on the prior
acceptanceofanother.Mutuallyexclusiveprojectsarealso
contingentprojects,where,fromasetofprojects,onlyone
project can be chosen. Here, the NPV rule requires
acceptanceoftheonewhichgivesthehigherpositiveNPV,
nomatterwhattheinitialinvestment.Someothercasesare
brieflydiscussedbelow:

i.

Optimalinvestmenttermforaproject,oritsduration:
Inthisproblem,theobjectistodeterminetheoptimal
lifeoftheproject,e.g.,whentoharvesttrees.In
thiscasewehavetoreplicatetheprojectatconstant
scaletoinfinity,thensetthederivativeofNPVto
zero to maximise it, and solve for time t. Some
projects need to be replicated with proportionate
growthinscale(Martin,1988:139).
ii. Projectswithdifferentlives:Here,therecouldbetwo
machineswithidenticalcapacitybutdifferentlives.
If the projects have the same risk, then the annual
equivalent cost (AEC), or the value of renting the
machines, is worked out. The machine with lower cost
wouldbepreferred(Copeland,1983:47).However,ifthe
projects have different risks, then this is not
appropriate, and we compute instead the NPV of an
infinite stream of constant scale replications. The
NPVsarethencomparedandtheprojectwithgreaterNPV
isaccepted.
iii. Projectsofdifferentscale: InthiscasethePresent
ValueIndex(PVI)canbeused(acceptallwhosePVI>1).
iv. Capitalconstraints/rationing:Thereissomedebateon
this point, since it is felt that there is no real
capitalconstraintintherealworld.Internal(soft)
constraintsaremorelikelythanexternal(hard)ones.
Ifthereisaoneperiodcapitalconstraint,thenthe
PVI can be used. For multiple period capital
constraints, two types of programming techniques are
applicable:linearprogrammingincasetheprojectsare
divisible,andintegerprogrammingincasetheyarenot
(Weingartner,1963,1977).However,thesetechniquesfail
whenuncertaintyisintroduced.
v.
Replacement problem: Here the question is whether to
continue with a machine or to replace it now. The
existing machine would have maintenance costs, but
would yield revenues and a salvage value. In such a
casetheAECofthenewmachinehastobeworkedout
andacomparisonmadewiththecostoftheoldmachine.
vi.Excesscapacitycosts:Thesparecapacitycreatedbya
project has to be charged to whosoever uses it, in
ordertovalueitproperly(Brealey,1988:109).
vii.Fluctuatingloadrequirements:Incaseofmorethanone
machine being required to meet fluctuating load
requirements,itispossiblethattheNPVofreplacing

oneorafewmachinesmaybegreaterthanreplacingall
ofthem(Brealey,1988:110).
viii.Treatmentofinflation: Here,boththecashflowsand
the opportunity cost of capital have to include (or
exclude)expectationsofinflation.Theproblemisof
course the estimation of the future inflation rate.
Usually, the term structure of interest rates is
considered, as it is felt to reflect expected
inflation.Accountmustbealsotakenofthediffering
effectsofinflationonvariousinflows/outflows.
6.NPVUNDERUNCERTAINTY
IncaseE(CF)andtheRADRasderivedusingtheCAPM
areused,then,thepresentvalueofanexpectedcashflow
E(CF)willbegivenby:
E(PV)=

E(CF)_
1+{Rf+[E(Rm)Rf)]proj}
SubtractingtheinitialoutlayIfromPV,wegetthe
E(NPV)=E(PV)I.ButE(NPV)canbedeceptive.Thereforeit
is always worthwhile doing some more study into the
viabilityoftheproject.
i)

ii)
iii)

Sensitivity analysis: Here we consider the major

variablesdeterminingaproject'ssuccessandestimate
how far the NPV would be altered by taking a very
optimisticoraverypessimisticviewofeachofthese
variables,oneatatime.
Scenarioanalysis:Inthistheeffectontheprojectof
afewcombinationsofvariablesisexamined.
Monte Carlo simulation: For large projects, it is
worthwhile to look at all possible combinations of
variables.Inthistechnique,amodeloftheprojectis
determined. The probability distributions of each of
thedeterminantsofcashflowarethenspecified.The
computer then gives random values to these variables
anddeterminesdifferentcashflows,andtheNPVs.This
givesrisetoafrequencydistributionofreturns.
Theaboveanalysiswillgiveamorecompletepictureof
the variability of the NPV, and depending on the risk
aversionofshareholders,abetterdecisioncanbetaken.


7. PRACTICALISSUESWITHDCFTECHNIQUES:

7.i

Capitalbudgetingtechniquesusedbyfirms:Inastudy
intheUSA,GitmanandForrester(1977:68)foundthatthe
mostpopularinvestmentappraisaldecisionruleistheIRR
(53.6%),followedbyARR(25%).TheuseoftheNPVhasbeen
increasing over the years, from 9.8% in the Gitman study
(1977),to68%inthePike(1988)studycarriedoutinUK.
Pikefoundthat:
a)
b)
c)

d)
e)
f)

h)

Almost 2/3rd of the sample prepare a capital budget

whichlooksbeyondtwoyears.
84%ofthefirmshaveinvestmentmanuals.
Capital budgeting is not regarded as a specialist
functionandonly26% ofthefirmsemploypersonnel
forcapitalbudgeting.
71%ofthefirmsreviewandsethurdleratesfortheir
projects.
86%ofthefirmscarryoutformalriskanalysis.
Firmsseemtouseabasketoftechniquestodecideona
project. They use the payback method in 92% of the
cases,IRRin75%ofthecasesandNPVin68%ofthe
cases.Manyofthefirmsusecomputermodelsfortheir
analysis.
ItwasalsofoundthatDCFmethodshaveprovedtheir
worth to firms, inspite of their many unavoidable
shortcomings.

7.ii DCF and the decline of American fortunes: M.E.Porter

(1992) has criticised the DCF system of evaluation of
projectsasbeingapossiblecauseoftherelativedecline
ofAmericanbusinessincomparisontoJapan.Hefeelsthat
DCFmethodshaveledUScapitalandfinancialmarketstoward
a shortterm gain orientation. Impatient investors force
business managers to maximise shortterm earnings rather
than in longterm growth. However, Bernstein (1992) shows
thatinvestorsarenotonlypatientbutpayapremiumfor
stocks of researchoriented companies. The cause of the
declineoftheUSlieselsewhereandnotinDCFtechniques/
financialmarkets.OnetendstoagreewithBernstein.

8. MERGERSANDACQUISITIONS(M&A):

M&A also constitute an investment decision. The

differenceisthatinM&A,pricesaresubjecttobargaining,
and it is difficult to measure incremental cash flows
accurately (Van Horne,1990:219). For M&A activity to be
beneficial,theremustfirstbeaneconomicgain.Forthis
tohappen,thetwofirmsmustbeworthmoretogetherthan
apart(synergy).Gain=PVAB(PVA+PVB)wherePVABisthe
present value of the merged firm, and PV A and PVB are
respectivelythepremergervaluesofthefirmsAandB.In
addition, the costs have to be worked out. One should go
ahead only when the gains exceed the costs. When the
acquisitionisfinancedbycash,Cost=cashPVB,andwhen
itisfinancedbyequity,thecost=PVABPVB.Thereare
different models which take account of efficiency,
information costs, agency problems, market power, tax
deductability,etc.,inmergersandacquisitions.Analysis
ofM&Aactivityisthereforeanindependenttopicitselfand
willnotbeconsideredherefurther.

9. STRATEGICREALOPTIONSANALYSIS
Under some uncertain situations, investment projects
could have options embedded in them: e.g., flexible
technologies and research and development projects. These
are called "real" options, to distinguish them from
financial options such as traded puts and calls. Real
options last longer and are more complex than financial
ones. They are distinguished by the timeseries links
between/within projects. Many of these also take the
"American" form, whereby they can be exercised before the
expirationdate.Suchaproject'sNPVcanbequitedifferent
fromonethathasnosuchoptionsembeddedinit.Veryoften
theembeddedoptioncantipcapitalinvestmentdecisionsone
wayortheother(Brealey,1988:495).Someofthecommonreal
optionsare(adaptedfromKulatika,1993):
i)

Investmenttiming:ApositiveNPVprojectisequivalent
toaninthemoneycalloption.Wewouldobviouslylike
to exercise this option at the best time. Thus all
projects have the option of being taken up now, or
later.Aleaseforoffshoreexplorationforoilcould
bemoreprofitableinthefuturewhenoilpricesrise
(Myers,1984).

ii)

Thereisalwaysanoptiontomakefollowoninvestment
iftheimmediateinvestmentprojectsucceeds(Brealey,
1988:495).
iii) Abandonment value: If a project fails, it is not
necessary to continue with it. Instead, if there are
active secondary markets for tangible secondhand
goods, then the project can be sold at higher than
salvage value. We must keep in mind that intangibles
haveusuallyalowervaluethantangibles.Thesecond
handmarketgivestheowneraputoption(Myers,1984).
iv) Shutdownoption:Theoptiontoshutdowncouldexistin
somecasesduringlowpriceperiods.
v)
Growth option: Sometimes a current investment could
facilitatefutureinvestmentopportunities.Insucha
casethecurrentprojectwouldhavealargerNPVthan
itwouldotherwisehavehad(Brealey,1988:469).
vi) Designedin option: This could include the option to
switch to cheaper inputs, to switch to a different
outputsandtoincludefutureexpansionrequirements.
vii) ResearchandDevelopmentprojects:ThevalueofR&Dis
almost all option; so also is the value of other
intangibleassets.
viii)Takeovers/acquisitions: A firm could sometimes be
acquired at premium, at a negative NPV, for purely
strategic reasons, for opening up investment
opportunitiesinthefuture.
This area was a part of financial strategy till
recentlyandnotamenabletoquantitativeanalysis.Butnow,
amixtureofDCFandoptionvaluationmodelsarecapableof
forging the missing link between finance theory and
strategicplanning.
Valuationofrealoptions:BanzandMiller(1978)haveshown
amethodofvaluingsuchoptions.First,theproblemisset
upinatimestatepreferenceframework.Second,theBlack
andScholes(1973)optionpricingmodelisusedtocalculate
the prices of the identified state contingent claims
identified (Martin,1988:510). One problem is that many of
theseoptionsareoftheAmericantypeandtheBSmodelhas
limitationswhendealingwiththese.Further,theabsenceof
asecondarymarketfortheunderlyingassetplacesserious
limitationsonthevalueofrealoptions.However,themere

recognitionofrealoptionsopensupareasforquantitative
analysisnotavailableearlier.

10.

CONCLUSION
Themanagerofafirmhastorecognisethatprojectsof
differenttypes,andmeetingdifferentassumptions,require
differentapproachestoinvestmentanalysis.WhereastheDCF
techniques and the CAPM have serve fairly well in most
cases,itisimportanttorecognisethatmanyprojectshave
realoptions,andrecognisingthiswouldreducethechance
of rejecting good projects. Mergers and acquisitions also
require a special analysis. But we must remember that
inspite of the theoretical advance made in asset pricing
underuncertainty,therearelimitationsimposedbythevery
nature of uncertainty in the analysis, and subjective
judgementhasultimatelytobeapplied,onceallavailable
dataiscompiled.Tothatextent,investmentappraisaltakes
onthefeaturesofanart,ratherthanascience.
But as Pike (1988) has found out, sophisticated
techniqueshavecometostayinspiteoftheselimitations,
and are making a positive contribution in improving
investmentdecisions.
References:
Bernstein,P.L.(1992)"AreFinancialMarketstheProblemor
theSolution?AReplytoMichaelPorter"inJournalof
AppliedCorporateFinance.
Bogue,M.C.andRoll,R.(1974)"CapitalBudgetingofRisky
Projectswith'Imperfect'MarketsforPhysicalCapital"
inJournalofFinance,May1974.
Bower,D.H.,Bower,R.S.,andLogue,D.E.(1986)"APrimer
on Arbitrage Pricing Theory" in Stern, J.M. and
Chew,Jr., D.H. (eds.) (1986) The Revolution in
CorporateFinance.BasilBlackwell.
Brealey, R.A. and Myers, S.C. (1988). Principles of
CorporateFinance.3rdedn.McGrawHillPublishingCo.,
NewYork.

Brigham, E.F., and Gapenski, L.C. (1990). Intermediate

Financial Management. 3rd edn. The Dryden Press,
Chicago.
Copeland, T.E., and Weston, J.F. (1983). Financial Theory
and Corporate Policy. 2nd edn. AddisonWesley
PublishingCo.
Fama,E.F.(1977)."RiskadjustedDiscountRatesandCapital
Budgeting under Uncertainty" in Journal of Financial
Economics,1977.
Gitman, L.J. and Forrester, J.R.,Jr. (1977) "A Survey of
CapitalBudgetingTechniquesUsedbyMajorU.S.Firms"
inFinancialManagement,Fall1977.
Hirshleifer,J.(1958)"OntheTheoryofOptimalInvestment
Decision" in The Journal of Political Economy,
Aug.1958.
Kulatilaka, N. and Marcus, A.J. (1993) "Project Valuation
underUncertainty:WhenDoesDCFFail?"in Journalof
AppliedCorporateFinance.
Martin,J.D.,Cox,S.H.,Jr.,andMacMinn,R.D.(1988). The
Theory of Finance: Evidence and Applications. The
DrydenPress,Chicago.
Myers,S.C.(1984)."FinanceTheoryandFinancialStrategy"
inInterfaces,JanFeb1984.
Pike,R.H.(1988)."AnEmpiricalStudyoftheAdoptionof
Sophisticated Practices and DecisionMaking
Effectiveness" in Accounting and Business Research,
Vol.18.
Porter, M.E. (1992) "Capital Choices: Changing the Way
America Invests in Industry" in Journal of Applied
CorporateFinance.
Rao, R.K.S. (1992). Financial Management: Concepts and
Applications.MacmillanPublishingCo.,NewYork.
Ross, S.A., Westerfield, R.W., and Jaffe, J.F. (1990)
CorporateFinance.Irwin,Boston.

Rubinstein, M.E. (1973) "A MeanVariance Synthesis of

Corporate Financial Theory" in Journal of Finance,
March,1973.
VanHorne,J.,Davis,K.,Nicol,R.,andWright,Ken.(1990).
FinancialManagementandPolicyinAustralia.3rdedn.
PrenticeHall,NewYork.
Weingartner,H.M.(1977)."CapitalRationing:nAuthorsin
Search of a Plot", in The Journal of Finance, Dec.
1977.
Weston,J.F.,andCopeland,T.E.(1989).ManagerialFinance.
8thedn.withtaxupdate.TheDrydenPress,Chicago.