CHAPT

COMPLEX INVESTMENT DECISIONS

LEARNING OBJECTIVES
2

Show

the application of the NPV rule in the choice between

mutually exclusive projects, replacement decisions, projects
with different lives, etc.
Understand the impact of inflation on mutually exclusive
projects with unequal lives
Make choice between investments under capital rationing
Illustrate the use of linear programming under capital
rationing situation

Complex Investment
Problems
How

shall choice be made between investments with

different lives?
Should a firm make investment now, or should it wait
and invest later?
When should an existing asset be replaced?
How shall choice be made between investments under
capital rationing?

Projects with Different

Lives

The choice between projects which have different lives should be

made by evaluating them for equal periods of time.

Example: A firm has to choose between two projects X and Y,

which are designed differently, but perform essentially the same
function. Cash flows of projects are in real terms and the real
discount rate is 10 per cent. The present value of costs are shown
below:

Projects with Different

Lives
Project

X has 4-year life while Project Y has 2-year

life. Project Y will be replicated to compare it with
Project X. Project Y costs more than project X.

Annual Equivalent
Value (AEV) Method

The method for handling the choice of the mutually exclusive

projects with different lives, as discussed in last slide, can
become quite cumbersome if the projects lives are very long.

We can calculate the annual equivalent value (AEV) of cash

flows of each project. We shall select the project that has lower
annual equivalent cost.
NPV
AEV
Annuity factor

AEV: Example
7

In the earlier example, the present value of cash flows of X is Rs

215,100. You can divide Rs 215,100 by a 4-year present value
factor for an annuity of Re 1 at 10 per cent (3.1699) to obtain
AEV. Similarly, AEV for Y can be calculated. Y is more costly.

NPV
Annuity factor
215,100
=
= Rs 67,857
3.1699
129, 420
=
= Rs 74,572
1.7355

AEVProject X =

AEVProject Y

AEV for Perpetuities

8

When

we assume that projects can be replicated at

constant scale indefinitely, we imply that an annuity is
paid at the end of every n years starting from the first
period.

(1 k ) n
NPV (NPVn )

n
(1

k
)

where NPV is the present value of the investment

indefinitely, NPVn is the present value of the investment
for the original life, n and k is the opportunity cost of
capital.

Nominal Cash Flows and

Annual Equivalent Value

Continue with earlier example. Let us assume expected inflation of

4% . The real cash flows of X and Y can be converted into nominal
cash flow (as shown below) and the real discount rate into nominal
discount rate: (1.04) x(1.10) -1=0.144. Notice that the ranking of
projects changes at higher inflation rate of 15%. Thus, the choice
should be based on real AEV.

Inflation and Annual Equivalent Value

10

Investment Timing and

Duration

The rule is straightforward: undertake the project at

that point of time, which maximizes the NPV.

Tree Harvesting Problem

11

The

maximisation of the investments NPV would

depend on when we harvest trees.
The net future value of trees increases when harvesting
is postponed; but the opportunity cost of capital is
incurred by not realising the value by harvesting the
trees.
The NPV will be maximised when the trees are
harvested at the point where the percentage increase in
value equals the opportunity cost of capital.

Tree Harvesting Problem

12

Suppose

the net future value obtained over the years

from harvesting the trees is At and if the opportunity
cost of capital is k, then the net present value (NPV)
of the net realisable value of trees is given by:

Tree Harvesting Problem

13

To

determine the optimum harvesting time, which maximizes

the NPV, we set the derivative of the NPV with respect to t in
Equation equal to zero.

Land

may have value since the trees can be replanted.

Therefore, the correct formulation of the problem will be to
assume that once the trees are harvested, the land will be
replanted. Thus, if we consider a constant replication of the
tree-harvesting investment indefinitely, then the NPV will:
( At C)
NPV C kt
e 1

14

Replacement of an
Existing Asset
Replacement

decisions should be governed by the

economics and necessity considerations.

An

equipment or asset should be replaced

whenever a more economic alternative is available.

Example
15

A company is operating equipment, which is expected to

produce net cash inflows of Rs 4,000, Rs 3,000 and Rs 2,000
respectively for next 3 years. A design, which is considered to
be a technological improvement and more efficient to operate,
has appeared in the market. It is expected that the new
machine will cost Rs 12,000 and will provide net cash inflow
of Rs 6,000 a year for 5 years. What should the company do?
Assume 12 per cent discount rate.

Example
16

The correct method of analysis is to compare the annual equivalent value (AEV) of the
old and new equipments as given below.
A chain of new machines is equivalent to an annuity of Rs 9,630 3.605 = Rs 2,671 a
year for the life of the chain. The existing machine is still capable of providing an annuity
of: Rs 7,390 2.402 = Rs 3,076. So long as the existing machine generates a cash inflow
of more than Rs 2,671 there does not seem to be an economic justification for replacing it.

Investment Decisions
Under Capital Rationing

17

Capital rationing refers to a situation where the firm is

constrained for external, or self-imposed, reasons to obtain
necessary funds to invest in all investment projects with
positive NPV.
Under capital rationing, the management has to decide to
obtain that combination of the profitable projects which yields
highest NPV within the available funds.

Why Capital Rationing?

18

There

are two types of capital rationing:

1.

External capital rationing: imposed by capital markets

2.

Internal capital rationing: self-imposed by the

company internally

Profitability Index
19

The objective of the NPV rule under capital constraint should be to

maximise NPV per rupee of capital rather than to maximise NPV.

Projects should be ranked by their profitability index, and topranked projects should be undertaken until funds are exhausted.

The Profitability Index does not always work. It fails in two

situations:

Multi-period capital constraints.

Project indivisibility.

20

Limitations of
Profitability Index
Multi-period

capital constraints
Project indivisibility

21

Profitability Index:
Example

The NPV and profitability index of the following four

projects are shown. Given the budget constraint of Rs 50,
projects M and N will be selected as per PI.

Programming Approach to
Capital Rationing

22

Capital

rationing presents a situation of maximising net

present value of several projects subject to funds
constraint. Hence, programming approach can be used
for decision making.

Linear Programming (LP)

Integer Programming (IP)
Dual variable

Example
23

Let us consider four projects L, M, N and O, given

earlier. The company has budget constraint of Rs 50
each in year 0 and year 1.

We

need to maximise NPV subject to budget

constraints. Since investments will be positive, we
will put as constraints.

Example
24

Maximize NPV

NPV =12.94 X L + 8.12 X M + 7.75 X N + 6.88 X O

Subject to:

The LP Solution of the problem:

Integer Programming
25

A large number of projects in practice are indivisible. When

projects are not divisible, we can use integer programming
(IP) by limiting the Xs to be integers of either 0 to 1.

Integer programmes are difficult to solve. It may take

unwieldy number of iterations for the model to converge on a
solution. Also, other restrictions may prove to be redundant on
account of integer restriction.

Dual Variable
26

Dual variables for the budget constraints may be interpreted

as opportunity costs or shadow prices. In the earlier
example, dual variables for the budget constraints in periods 0
and 1 respectively, are 0.344, and 0.086.
The dual variables of 0.344 for period 0 imply that NPV can
be increased by Rs 0.344 if the budget in period 0 is increased
by Re 1. In other words, the opportunity cost of the budget
constraint for period 0 is 34.4 per cent, and for period 1 it is
8.6 per cent. Dual variables provide information for deciding
the shifting of funds from one period to another.

27

Extensions of
Programming Approach
The

use of LP or IP models can be extended to

cope with other constraints.

firm may like to provide for the carry over of

unspent cash from one period to another.

In

addition to financial constraints, non-financial

constraints can also be included.

Limits to the Use of

Programming Approach
28

First,

they are costly to use when large, indivisible

projects are involved.

Second, these models assume that future

investment opportunities are known. The discovery
of investment opportunities in practice is an
unfolding process.

29

Capital Rationing in
Practice
Capital

rationing does not seem to be a serious

problem in practice.

It

may arise due to the internal constraint or the

managements reluctance to raise external funds.

When

companies face the problem of shortage of

funds, they use simple rules of choosing projects
rather than the complicated mathematical models