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ANALYSIS AND EVALUATION OF INVESTMENTS


Original written by professor Javier Vega Fernndez at IE Business School. Original version, 27 November 1997. Last revised, 16 October 2008. Published by IE Business Publishing, Mara de Molina 13, 28006 Madrid, Spain. 1997 IE. Total or partial publication of this document without the express, written consent of IE is prohibited.

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INTRODUCTION
One of the most common tasks a financial director faces is deciding how to use the money that the investors (shareholders and bankers) have made available, i.e. how to distribute these resources between the companys assets in order to obtain the highest rate of return. This concept of highest rate of return implies a hierarchization of the possible alternatives, and thus, the adoption of some or other classification criterion for them. The traditional name for this financial tool is Analysis and Evaluation of Investments. The purpose of this chapter is to describe the methods that are used by financial directors to rank and select investments and to choose between them. The methods presented are those that up to now have proved most appropriate for making decisions in this key area of finance. The argument will be developed on the basis of a simple example that we will progressively expand and make more complicated as necessary. At the end we will try to bring together all the fundamental concepts that we have obtained from the argument.

INVESTMENT ANALYSIS: AN EXAMPLE


The firm Plstica, S.A. has to decide about the Alpha Project, which requires the expansion of its plant in order to meet increased demand envisaged over the next five years. The forecast investment and profits are as follows:

TABLE 1
Alpha Project (in millions of pesetas) New Machinery Additional Sales Cost of Sales Depreciation (6 years) Profit before Tax Taxes Profit after Tax 0 1200 700 420 200 80 28 52 1000 600 200 200 70 130 1300 780 200 320 112 208 1600 960 200 440 154 286 1900 1140 200 560 196 364 1 End of year 2 3 4 5 6

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Investment analysis uses a number of conventions that need to be clarified before continuing. End of period 0 is used to denote the start of the project. It is therefore not an interval of time, but the moment when the money has to be invested to start the business activities in question. It can also be identified with the start of period 1. In each of the following periods the activities accumulated during the period, such as sales, costs, taxes and new investments, are concentrated at the end. The periods do not have to be annual; they can be two-year or daily intervals, as suits the project best. However, they do all have to be equal. In other words, annual periods cannot be mixed with six-monthly or monthly periods. Lastly, once the lifetime of the project has been defined five years in our case an additional period is usually added to wind up the project, so that once all the business activities have been finished, the residual value of the assets is recovered.
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Having considered these points we can now start to analyse the Alpha project. The proposal is to invest Pta1,200 million in new machinery. This investment will be repaid by the additional sales generated, which will produce the profits specified in Table 1. The information we have, as is usual in business language, is purely accounting data. We know that our assets will increase by Pta1,200 million and that the companys profits will increase over the coming five years. With these data we can obtain an initial measure of the profitability of the investment known as Book Yield.

BOOK YIELD
The Book Yield relates investments to the profit obtained from them. It uses average magnitudes based on the years of duration of the project. It is defined as the percentage average annual profit divided by the average investment over the lifetime of the project.
BookYield Pr ofit average Investment average x100

In our example, the average profit (the sum of the income divided by five) in relation to the average 1 investment (money invested divided by 2 ) is equal to:
BookYield 208 x100 41.6% 500

The book yield tells us that the average annual profits from the Alpha project are 41.6% of the average investment, if we give the project a life of five years. We now have our first criterion for selecting investments, namely book yield. It would seem reasonable to assume that investments with a book yield of more than 41.6% would be preferable to the Alpha project, and those with a book yield of less than this would be postponed in favour of it.

THE DRAWBACKS OF BOOK YIELD The book yield fulfils the objective of classifying investments in a ranking from the most to least desirable, but does not take two important factors into account. The difference between earning money (which is represented by profit) and actually having it available, and the influence of the passing of time on the value of money.

The average investment will be: initial outlay of 1,200 less residual value of 200, as only 1,000 are depreciated over the five years, divided by 2.

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THE BOOK YIELD DOES NOT TAKE INTO ACCOUNT THE AVAILABILITY OF FUNDS The fundamental problem with book yield is that it is calculated by relating magnitudes which are almost never homogeneous: investments and profits. Investments necessarily imply making payments, but profits do not always imply receiving funds. Profit is money that is earned on the books but does not always reflect money that the company has in the form of cash in hand. We will come back to this later, as it is a fundamental point for understanding the relationship between accounts and finance.

BOOK YIELD DOES NOT TAKE INTO ACCOUNT THE VALUE OF MONEY OVER TIME
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In our example we calculated the book yield using the following data:
Alpha Project 0 New Machinery Profit after Tax Book Yield 1,200 52 130 208 286 364 1 End of year 2 3 4 5 Medium 500.0 208.0 41.6%

However, we can imagine the possibility of other investments which generate equal profit payments, and therefore have the same book yield, but which have a different distribution over time. For example:
Omega Project 0 New Machinery Profit after Tax Book Yield 1,200 364 286 208 130 52 1 End of year 2 3 4 5 Medium 500.0 208.0 41.6%

Both investments have the same book yield, but the Omega Project produces a profit earlier than the Alpha Project. Thus, if this profit were available as soon as it was generated, and if the value of this money decreased over time, Omega would be a better alternative than Alpha. It therefore seems to be the case that book yield classifies as equivalent investments which produce different financial outcomes. This obliges us to continue our analysis in search of more accurate tools. To do this we will try to eliminate the problem caused by the heterogeneity between the payment of investment and profit.

THE CONCEPT OF AVAILABLE CASH FLOW


We mentioned earlier something which should seem obvious: its not the same thing to earn money as to actually have it. Take the case of an enterprising teenager who wants to set up a simple business. His idea is to sell photocopies at the entrance of his school using a portable photocopier. He made a quick calculation. The photocopier costs a hundred thousand pesetas. If he sold 1000 copies a day with a profit margin of 3 pesetas each, in less than two months he would have recouped his investment. Having made the decision and bought the machine he realizes that he has to buy paper for it. This implies an additional investment of pta10,000 which he hadnt considered at the outset. Nevertheless, he presses on and starts his business. His first customer asks him to photocopy 10 pages of notes and he pays him with a thousand peseta note. Yikes! We forgot about the change. It seems we need additional funds to serve wealthy customers. Then, a course representative wants to make photocopies for his fifty classmates, but he asks for two months to pay. This causes a delay in the envisaged inflow of money.

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We could continue, but I dont think its necessary. Our young students profit forecasts havent changed, but what has changed is his chance of recouping his investment in two months. Accounting tells us about profit, which is the difference between income and expenses, but this is almost never the same thing as the difference between collections and payments, which is what we have to calculate if we want to know how much money we have available at any given moment. To do this we need to obtain additional information and then use it to make adjustments to the profit and loss account. Lets go back to the Alpha Project. We have information about the profit and loss account, but we have no information about the form collections and payments are to take. Lets set up the following hypothesis:
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Collection period.- Suppose that sales are paid for with a delay of three months. Payment period.- We will pay the cost of sales three months later and taxes the following year. Cash in hand needed for contingencies is set at 1% of sales. Stock will be two months of costs.

With this information we can now build a financial statement which at the same time tells us how much money we will earn and how much cash in hand we will generate for our business. Table 2 shows the results.

TABLE 2
Alpha Project 0 New Machinery Sales Cost of Goods Sold Depreciation Profit before Tax Taxes Profit after Tax Depreciation Cash Flow - Cash in hand invested (1% of sales) - Customer investment (90 days of sales) - Investment in stock (60 days of costs) + Supplier finance (90 days of costs) + Tax finance (1 year) Cash generated by operations - Investment in Fixed Assets Net Cashflow 1200 -1200 133 309 387 465 543
2

End of year 1 2 3 4 5

1200 700 420 200 80 28 52 200 252 7 175 70 105 28 133 1000 600 200 200 70 130 200 330 3 75 30 45 42 309 1300 780 200 320 112 208 200 408 3 75 30 45 42 387 1600 960 200 440 154 286 200 486 3 75 30 45 42 465 1900 1140 200 560 196 364 200 564 3 75 30 45 42 543

The sums indicate how much needs to be invested in each period, i.e. in year 1 we should invest 175 million in customers (a quarter of sales, representing the three months delay in collections). In year 2 the total investment in customers would be 250 million, but as we have already taken into account the 175 million from the previous year, the additional investment will be just 75 million. And so on, for all the entries.

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Table 1 ended with the profit forecast for the first five years. The first adjustment we need to make in order to calculate the money available is to eliminate from the profit and loss account the costs which accrue, but are not paid, as in the case of depreciation. Depreciation is an accounting concept which seeks to assign to each period the cost of using machinery in the production process. This cost is not a payment. The machinery was paid for when it was bought. It is therefore added to profit to eliminate its distorting effect on the calculation of available cash. The sum of profit and depreciation has always been defined as cash flow, and is a frequently-used concept among financial analysts. As financial terms in English tend to be fairly precise, perhaps we should ask ourselves what this term means. Well, if we assume all sales are paid for during the year they are made (and only these sales) and all expenses are paid, except depreciation, (but 3 only these expenses), the cash available in each year will be the same as profit plus depreciation . The cashflow expresses how much money the activities of a business produce, before taking into account the investments that need to be made to earn this income. But, from the simple example of the teenage entrepreneur, the cashflow, understood as the resources generated by the business activity, is not enough to quantify the money really produced by a business. As well as investments in fixed assets we need to invest in cash in hand, customers and stock. At the same time, we receive finance from suppliers, creditors and from the state via taxes. It would seem logical that we subtract the investment in current assets from the cashflow and add to it the finance we obtain from our suppliers and creditors. These additions and subtractions enable us to calculate what is known as Cash Generated by Operations, which is defined as the money available for other uses generated by a business or business activity. This concept is important in finance. It quantifies the money generated by a business which can be used on a discretionary basis. This means that if our forecast is met, this cash will be available to 4 repay investors or finance new business . It also tells us both how much money the investment produces and when it produces it. We can now compare the investment in the Alpha Project (the cash we have to pay out) with the Cash Generated by Operations from our estimates (the money we are going to obtain as a result of our investment), referred to in Table 2 as Net Cash Flow, as both variables are homogeneous in both economic and temporal terms. The first method of comparison we are going to use is the Payback Period of the Investment.

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THE PAYBACK PERIOD OF THE INVESTMENT


The payback period is a calculation of the number of years needed to recoup the initial outlay. It is an easy index to calculate and is in widespread use among business people with an intuitive approach who feel that sophisticated calculations in business are nothing more than a waste of time. The payback period is normally calculated comparing the investment with the profit, but we are going to calculate it using the net cash flow. The numbers we need are at the end of Table 2.
Alpha Project 0 Net Cashflow Accumulated Net Cashflow -1200 133 -1.067 1 309 -758 End of year 2 387 -371 3 465 94 4 543 637 5

The calculation is very simple. If during the first year in our example we receive payment for all sales, 700 million will be collected. If we pay all the expenses due (cost of goods sold plus taxes) 448 million will be paid out. The flow (variation) of cash would be assuming we start at 0 700-448 = 252, which is identical to the cashflow. Uses other than those cited are hard to justify. We cannot leave it as cash in hand if we want to maintain the hypothesis of 1% of sales. We cannot finance more customers, because in this case our hypothesis that they pay after three months would not be true. And so on, with all the items which affect the cash generated.

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By calculating the accumulated net cash flow we see that the investment is recouped during the fourth year. A more exact calculation would be:
3 yrs 371 3.8 years 465

or approximately 3 years and 10 months.

THE ADVANTAGES AND DISADVANTAGES OF PAYBACK Lets compare the Alpha Project with another alternative the Delta Project whose net cash flows are as follows:
Delta Project 0 Net Cashflow Accumulated Net Cashflow -1,200 -1,200 1 2 0 -1,200 End of year 3 0 -1,200 4 0 -1,200 5 14,400 13,200

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The table shows Project Delta to have a payback period of four years and one month. This is longer than the Alpha Project, but it seems a bit strange that a project that produces 14,400 million from an investment of 1,200 can be worse than another which only produces 1,8375 on the same investment, only because it is paid back later. We can also compare it with Project Gamma:
Project Gamma 0 Net Cashflow Accumulated Net Cashflow -1,200 1 1,100 -100 2 110 10 End of year 3 0 4 0 5 0

Project Gamma has the shortest payback period less than two years but produces the least money of the three projects. Thus it is clear that the payback period is somewhat inconsistent in its classification of investments. Moreover, it is not a method that takes into account the profitability of the project, but focuses instead on its ability to produce money quickly. This is because it only considers the net cashflow needed to recoup the investment to be relevant and ignores the rest. This means that the payback period is more concerned with liquidity than profitability. Despite its defects, the payback period method does have a positive side to it. Albeit indirectly, it is introducing into our analysis a factor that so far we have not taken into account: risk. Of our three investments the one which produces most money is without doubt Project Omega. However, it obliges us to have 1,200 million tied up for four years without getting anything back. On the other hand, Project Gamma hardly produces any profit at all (indeed it starts at a loss) from the point of view of the value of money over time, but it does allow us to get our money back in just over a year. If there was a chance that the project would not complete its projected life and income could cease to be generated, it may be the case that the most profitable projects are no longer attractive on account of the risk they entail. Nevertheless, payback is not a complete method. So our search for a way of classifying investments must continue.

1,837 million is the result of accumulating the cashflow of the Alpha Project without including the 1,200 investment.

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THE FUTURE VALUE AND PRESENT VALUE OF NET CASH FLOW


In the previous chapter we have analysed how value is placed on money that we are due to receive in the future by means of a calculation of Future Value and Present Value. We shall now try to apply the same reasoning to the Alpha Project.

FUTURE VALUE After making the appropriate adjustments to the accounts information provided by the forecasts we have reached the conclusion that the money that we are going to invest, and the money we are going to receive, and when we are going to receive it, is faithfully represented by the net cash flows shown at the end of Table 2.
Alpha Project 0 Net Cashflow -1200 1 133 2 309 End of year 3 387 4 465 5 543

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Lets now analyse the information we have available. We know that if we invest 1200 million today in Alpha, we have the possibility with a certain degree of risk that it not be fulfilled of obtaining a series of net cash flows over the next five years. Lets suppose that in projects with a similar degree of risk the investors we represent want to obtain a profitability of 15%6. Using these data we can start to apply our knowledge of the value of money over time. The first thing we can do is calculate what the future value of the 1,200 million would be if we invested it at 15% in a hypothetical alternative project. Also, to be consistent, we should assume that the net cash flow produced by Alpha over the next five years can also be invested at 15% as it is produced7. Lets take a look at the results:

TABLE 3
0 1,200.00 133.00 309.00 387.00 465.00 1 2 3 4 FV in the year FV = 1.200x(1.15) FV = 133x(1.15)
4 3 2 1 0 5

5 2,413.63 232.62 469.95 511.81 534.75 543.00 2,292.13

FV = 309x(1.15) FV = 465x(1.15)

FV = 387x(1.15)

FV = 543x(1.15)

In Table 3 we can compare two future values, that of the 1,200 million invested at 15% over five years, and that of the net cash flows that would be produced by the 1,200 million invested in the Alpha project, bearing in mind that these cash flows are also reinvested at 15% for the number of years for which this is feasible (the net cash flow from the first year can only be invested for four years in the alternative investment, the cash flow from the second year can only be invested for
6

The next chapter will explain how we obtain the rate of return required for investment projects as a function of the risk. We will simply assume for now that this figure is 15%. 5 The future value of the 1,200 million at the end of the five year period will be 1,200x1.15 , which means that at the end 2 of the first year its future value will be 1200x1.15, at the end of the second year 1,200x1.1.5 , and so on. In other words, the investment at 15% is available over the whole five-year period. Therefore, to be consistent, it will also be available for the net cash flow produced by Alpha.

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three years, and the cash flow from the fifth year cannot be re-invested as there is no time available). The results show that we would be better off if we invested the 1,200 million in the alternative business and not in Alpha, given that the future value of the other project is 2,413.63 million, whereas the sum of the future values of the cash flows from Alpha only come to 2,292.13 million (not forgetting that we reinvest them). This means that investing in Alpha would reduce our profit by 2,413.63-2,292.13=121.5 million over five years. We can also look at it a different way. If our investors demand a rate of return of 15% over five years, it is our duty to give them 2,413.63 million at the end of this period for the 1,200 that they entrust to us now. If we decided to go ahead with Alpha we could only give them 2,292.13. 8 Therefore we cannot undertake Alpha if we want to fulfil our obligation . It should be noted that we are not saying that Alpha is a bad project. Rather, we are saying that it is not good enough, i.e. not that it is not profitable, but that it is less profitable than projects giving a return of 15%. Future Value is a good system for choosing investments as it allows us to know which of the alternatives will makes us richest in the future. Nevertheless, it is not a commonly used method, as students of finances have tended to prefer, for reasons we shall explain below, to use the concept of Present Value.

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PRESENT VALUE Future Value is an intuitive concept. Which route will make us richest? On the other hand, Present Value is more abstract and needs mathematical logic to be understood properly. But, if we have been able to transport our money into the future using our time machine, we shouldnt have any difficulty in bringing future money into the present. Lets see how this can be done. We know that the return required by the investors (which we shall call r) sets up a correspondence when moving back and forth in time (n) between the Future Value (FV) and the Present Value (PV). In mathematical terms this means that,
n if FV = PV x (1+r) , then,

PV

FV (1 r )n

or, in other words, in our example, if the FV of the 1,200 million in five years, at 15%, is 2,413.63, the PV of 2,413.63 million in five years is 1,200.
5 If FV = 1,200 x (1+0.15) = 2,413.63, then,

PV

2,413.63 (1 0.15) 5

1,200

Remember that in most cases fulfilling your obligations is the fundamental reason why you get paid at the end of the month.

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If this is the case, then we can also establish the same correspondence between the FV of the Net Cash Flows and their PV. Thus the PV of the FV9 of the Net Cash Flow from the first year would be:

PV

FNn ofNCF1 (1 r )
n

232.62 (1 0.15) 5

115.65

And, the sum of all the present values:

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PV (1 0.15)5 (1 0.15)5 (1 0.15)5 (1 0.15)5 (1 0.15)5

232.62

469.95

511.81

534.75,

543.00

2,292.13 1.139,59 (1 0.15 )5

This formula can also be written as follows, if we take a look at Table 3:

PV

133 x1.15 4 , (1 0.15) 5

309 x1.15 3 (1 0.15) 5

387 x1.15 2 (1 0.15) 5

465 x1.15 1 (1 0.15) 5

543 x1.15 0 (1 0.15) 5

2,292.13 (1 0.15) 5

1,139.59

And if we eliminate the factors which repeat in the numerator and denominator, the sum would look as follows:

PV (1 0.15)

133

309 (1 0.15)
2

387 (1 0.15)
3

465 (1 0.15)
4

543 (1 0.15) 5

1,139.59

This is the formula that is given in all the text books for calculating the PV of a series of net cash flows. So why have we messed around with the net cash flows, moving them to the future and then back to the present if we could have updated them directly using the formula given in the textbooks? Please be patient. We will first analyse the results and then explain the apparently needless journey. The sum of the Present Values of the cash flows of the Alpha Project is Pta1,139.59 and to obtain them we need to invest Pta1,200. What is the significance of these figures? Thats simple. Earlier we said that investing in Alpha would have meant our investors would have forgone Pta121.5 million in five years, compared with an alternative investment with a rate of return of 15%. Therefore, the fact that the PV of the net cashflows is less than the investment requirements would mean that choosing Alpha would cause us to lose 2,100 - 1,139.59 = 60.41 million pesetas now. This implies that by making this decision we have already made our investors poorer by Pta60.41 million10. PV is a useful tool for assigning a value to net cash flows. Businesses operating in spot markets buying and selling for cash on the same day only need two pieces of information: how much the goods cost and how much they can be sold for. If the price is higher than the cost they proceed with the transaction, if not they reject it. What PV does in term businesses that need payments today to receive income in the future is give them the appearance of businesses operating on a cash basis. The PV is what the business activity is worth. The initial outlay is what it costs to put it into operation. So, if an investment is worth more than it costs, then it is accepted. Otherwise, if it costs more than it is worth, it is rejected. This is a good interpretation of PV, and it leads us to the most popular concept in investment analysis, namely Net Present Value.

10

Note that we are calculating the Present Value of a Future Value corresponding to the fifth year, and not the PV of a FV corresponding to the first year. This distinction is an important part of understanding how Present Value should be applied correctly. Obviously, the Future Value of 60.41 in five years at 15% is Pta121.5 million, and the Present Value of Pta121.5 over the same period is Pta60.41.

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NET PRESENT VALUE (NPV)


The NPV is the difference between the outlay made at time zero and the PV of the future net cash flows. Its mathematical expression is:
NPV Investment PV,

Which, if we extend it and make it more general, becomes:


NPV Investment
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NCF1 (1 r )
1

NCF2 (1 r )
2

...

NCFn (1 r ) n

In this formula the outlay is the investment at time zero, the cash flows represent the income during the lifetime of the project and r is the rate of return desired by the investors backing the project, or the rate available on other alternative investments. In our example the result would be: 133
1

NPV 1,200

309
2

(1 0.15) (1 0.15)

387 (1 0.15 )
3

465 (1 0.15)
4

543 (1 0.15) 5

60.41

We already know what this negative NPV means. It implies that the money we have to invest would be Pta60.41million more than we are going to get for doing it, which means this cant be considered an acceptable investment. In general, the NPV represents the difference between what an investment is worth and what it costs. So, a negative NPV tells us that an investment costs more than it is worth and warns us against the investment as it would make us less wealthy than we would wish. A positive value of NPV implies that the investment is worth more than it costs and so recommends it, because it makes investors richer. An NPV of zero means that the investment is worth what it costs, i.e. it produces the same return as the hypothetical investment at 15%.

THE DISCOUNT RATE


The popular understanding of the calculation of PV or NPV is discounting cash flows. Discounting implies reducing or diminishing the value of future money using what is known as the Discount Rate. The next chapter will deal with the discount rate, which is the rate at which investors can invest their money in alternative businesses to the one under consideration. The application of a reference rate was seen very clearly when we were comparing the FV of the cash flows of Alpha with the FV of an alternative investment at 15%. Thus, given the mathematical correspondence between Future Value and Present Value, the investment rate that turns PV into FV must be the same as the one that turns FV into PV. The Discount Rate is therefore the rate of return that the investors want to get from the business in question, because it is what they could get from alternative investments.

A REFLECTION REINVESTMENT

ON

NPV:

THE

HYPOTHESIS

OF

NET

CASH

FLOW

The NPV formula in point 6 has the advantage that it is easy to apply. Moreover, financial calculators and spreadsheets make it easy for us to use by adapting their programs so that we can obtain results almost effortlessly. This should not mean that we forget the hypothesis on which our working tool is based. When we calculate the NPV using the classic formula we should bear in mind that it is a simplification of the original and that the denominators (1+r) in the first year, (1+r)2 in the second year, etc. are based on the assumption that the net cash flows are reinvested at the same rate as that we are discounting, i.e. the rate of return the investors want to obtain. Without this simplifying hypothesis the NPV formula becomes:

10

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NPV Investment

NCF1x(1 t )(n1) (1 r )
n

NCF2 x(1 t )(n2 ) (1 r )


n

...

NCFn1x(1 t )1 (1 r )
n

NCFn (1 r )n

where the new element t represents the reinvestment rate at which the net cash flows arising during the lifetime of the project can be invested. This is important as it is only when we accept the hypothesis that r is equal to t that we can use the simplified NPV formula. When this is not the case, we should include the reinvestment rate in the numerators of our formula and change the exponents of the bracketed parts of the denominators. Returning to our example, let us suppose that, in our opinion, we will not be able to reinvest the net cash flows from the Alpha project in anything. In this case the NPV would be:
NPV 1,200 133
5

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309
5

(1 0.15) (1 0.15)

387 (1 0.15)
5

465 (1 0.15)
5

543 (1 0.15) 5

286.69

As you would expect, this is less than the previous case, as now there is no accumulated interest on the reinvested cashflows. Lets now take another hypothesis. Lets suppose that we have the opportunity to reinvest the cash flows in a prosperous business producing 20%. In this case the NPV will be:

NPV 1 200 ,

133 x1.2 4 309 x1.2 3 (1 0.15) 5 (1 0.15) 5

387 x1.2 2 (1 0.15) 5

465 x1.21 (1 0.15) 5

543 x1.2 0 (1 0.15) 5

27.04,

In other words, we have achieved a positive NPV thanks to the reinvestment of the cash flows at a rate higher than 15%. In short, be careful when you use NPV and before applying it think whether, in the specific case in question, you can assume that the reinvestment rate is the same as the discount rate.

USE OF THE INTERNAL RATE OF RETURN (IRR)


In the previous chapter we defined the IRR as the discount rate which makes the NPV zero. In our example we have seen that if we use 15% as the discount rate the NPV is negative to the tune of Pta60.41 million. But what would happen if we used a lower rate, say 14%. Obviously the NPV will be bigger, i.e. less negative. Its value comes out at -27.02 million. If we continue to reduce the rate, the NPV will gradually get bigger until it reaches 13.22%, which is the rate which makes the NPV zero. This is known as the IRR of the project. The IRR marks the boundary between investments with a positive NPV and those with a negative NPV. If we compare discount rates with the projects IRR we can say that discounting a discount rate higher than the IRR would imply a negative NPV, and therefore the rejection of the investment. Discounting discount rate equal to or lower than the IRR would imply a zero or positive NPV, and thus recommend starting the project. From the financial directors point of view this is the same as saying: If my investors want to earn 15% and the IRR of the project is equal to or higher than this rate I should undertake the project as it will make my investors as rich as, or richer than, their expectations. If the IRR is less than 15% I shouldnt invest in the project as it will make the investors less rich than they want to be.

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THE DRAWBACKS OF IRR

The Internal Rate of Return is a very convenient method for classifying investments. We just need to calculate the IRR of the different alternatives and rank them from highest to lowest. If we have a pre-set discount rate, any investment whose IRR is greater than this will be an acceptable business venture for the company, and if we can only choose one of them, we should take the one with the highest IRR. However, the IRR has two serious drawbacks. The first is that the cash flows are reinvested at the discount rate. The mathematical definition of the IRR is as follows:
NCF1 (1 IRR)
1

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0 Investment

NCF2 (1 IRR)
2

...

NCFn (1 IRR)n

The expression is telling us that in order to calculate IRR it is necessary for the cash flows to be invested at the same rate. This gives rise to the paradox that investments with a high IRR are so because we reinvest at a high rate of return, and contrariwise, those with a low IRR are so because we reinvest at a low rate of return. It would be a bit like saying: Business ventures with high cash flows with respect to the initial outlay are even better than they look because we reinvest these cash flows at high rates. Or the opposite, investments with low cash flows with respect to the investment are not only disappointing because of this, but also because these cashflows are reinvested at low rates. This reasoning, which is implicit in the calculation of IRR, does not seem very correct. Its use can therefore be problematic if this is not taken into account. The second problem is purely one of mathematical calculation. The IRR works very well when only the initial outlay is negative and the cash flows are all positive. But when positive and negative cash flows are mixed during the lifetime of the investment, the behaviour of IRR becomes erratic and not very useful. This is due to the fact that linear equations of degree n (i.e. those equations in which the unknown is raised to the power n) have as many solutions as the degree of the exponent (n), i.e. second order equations have two solutions, third order equations have three, etc. When there is only one change of sign in the formula these solutions are the same, but when there are several, the solutions may be different, giving rise to a situation in which the IRR of an investment is both 15% and -12%, for instance. When an investment project gives a result of this kind, we should give up on IRR as a classification criterion and resort to NPV, which will never cause this kind of problem.

ANOTHER LOOK AT THE ALPHA PROJECT


We will now finish our analysis of the Alpha Project by applying the various methods we have been using in this chapter. To do this we will repeat Table 2 with a few references to the residual value which we didnt consider in the previous analysis.

CALCULATING RESIDUAL VALUE

In our forecast we gave the Alpha Project a lifetime of five years. After this time we assume that the business activity producing the cash flows will cease. However, that doesnt mean that the assets we have been using up until that time evaporate. They will still be there, so we can assign them a value. In some cases this value will be easy to calculate, and in others it will be nothing more than an opinion. Bearing this problem in mind we will try to calculate the residual value of the Alpha Project assets. Apart from the 1,200 million invested in fixed assets, the first investment quantified in our project is the investment in cash in hand. Every business needs a certain minimum amount of cash to be

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IE Business School ANALYSIS AND EVALUATION... DF2-172-I

able to function, this is the change the teenage entrepreneur needed for his photocopy business. Our forecast cash needs were 1% of sales, which will oblige us to invest 7 million the first year and 3 more in each of the following years as sales increase. This means that at the end of the fifth year we will have Pta19 million in liquid cash which we will no longer need for anything. We can therefore consider these funds to be recoverable in their totality.

TABLE IV
Alpha Project 0 1 2 Year 3 4 5 6

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New Machinery Sales Cost of Goods Sold Depreciation Profit before Tax Taxes Profit after Tax Depreciation Cash Flow generated - Cash in hand invested (1% of sales) - Customer investment (90 days of sales) - Investment in stock (60 days of costs) + Supplier finance (90 days of costs) + Tax finance (1 year) + Residual Value of Fixed Assets Cashflow generated by operations - Investment in Fixed Assets Net Cashflow Investment Analysis Without residual value Book yield (in %) Payback period (in years) PV at 15% (in millions of pesetas) NPV at 15% (in millions of pesetas) IRR (in %) With residual value Book yield (in %) Payback period (in years) PV at 15% (in millions of pesetas) NPV at 15% (in millions of pesetas) IRR (in %)

1200 700 420 200 80 28 52 200 252 7 175 70 105 28 133 1200 -1200 133 309 387 465 543 276 1000 600 200 200 70 130 200 330 3 75 30 45 42 309 1300 780 200 320 112 208 200 408 3 75 30 45 42 387 1600 960 200 440 154 286 200 486 3 75 30 45 42 465 1900 1140 200 560 196 364 200 564 3 75 30 45 42 543 -19 -475 -128 -285 -196 +135 276

41.6% 3.8 1,139.59 -60.41 13.22%

41,6 3,8 1.246,81 46,81 16,26

The second investment is in customers. The first year we forgo the collection of Pta175 million (three months sales). In the following years this amount increases, as invoicing increases, at a rate of Pta75 million a year until at the end of the fifth year unpaid bills by customers are worth Pta475

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million. Here we can assume either that all our customers are going to pay us after the business has ended, or that some are not going to. In this case weve been optimistic and expect to recover 100% of the sums due on our customer accounts. The same is not true of the stock that will build up over the years. Its book value will be Pta190, however, we do not expect to be able to sell it at this price. Rather we estimate that that a discount of 50% will be necessary to be able to sell the stock off at the end of year 6. Selling goods at less than their book value brings us into a new area of analysis: the tax shield of loss. If we sell the 190 million of stock at 50%, the money that we receive will be 95 million. But, also, in our accounts the following will happen:
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Sale of stock (1) Book value Losses Tax shield of 35% (2) Change in cash (1)+(2)

95,00 190,00 95,00 33,25 128,25

The book loss that the liquidation of stock will imply will mean that we pay less tax to the tune of Pta33.25million and thus the change in our cash position as a result will be Pta128.25 million: 95 million will be paid in as a result of the sale of stock and 33.25 will not be paid out as a result of the tax shield given by selling below cost. Lets continue with our liquidation. Now we have to value the finance. Both our suppliers and the state will finance us during the first five years, in relation to purchases and profit before tax, respectively. When this business venture is over we will have to pay them what we owe them, and it would seem reasonable to suppose that we will pay in full. For this reason the accrued monies owing to suppliers and as a result of tax due are subtracted from the income from cash in hand, customer accounts and stock. Lastly, we are left with the valuation of the tangible assets, which we estimate that, in this case, could be sold as stock for 50% of their book value. The calculations are as follows:

Initial tangible assets Accrued depreciation Book Value of Fixed Assets Sale price (1) Losses Tax shield of 35% (2) Change in cash (1)+(2)

1.200 1.000 200 100 100 35 135

As in the case of stock, the sum received in payment for the sale of the fixed assets is increased by the tax shields originated by the book losses. We now have all the items of which residual value is comprised. These are shown in the last column of Table IV. Each of the sums has the corresponding sign; cash, customers and stock are negative because they are divestments, and suppliers and tax because they are decreases of financing (the signs that go before the investment and finance items should not be forgotten). Finally, note that we have included a new row in which the residual value of the tangible assets is quantified. The sum of all the residual values less the refunds of financing comes to Pta276 million.

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In the bottom part of Table IV two modes of investment valuation method have been applied to the Alpha Project, one not taking into account the residual value and the other valuing it at Pta276 million. This enables us to draw the following conclusions:

Neither the book yield nor payback period are affected by the inclusion of residual value. The former because it only takes into account the profits and the investment, and the latter because it does not consider more cash flows than are needed to recoup the initial investment. PV, NPV and IRR are affected by the inclusion of the new cash flow, which proves them to be more sensitive to changes in the amount of money produced by a project than the methods above. The Alpha Project is very close to being profitable, and an increase in the cash flow, in this case by including the residual value11, has changed it from being rejected to recommended, i.e. it is worth more than it costs, and its IRR is higher than the discount rate used in alternative projects, or in other words, it is more profitable than other similar opportunities investors are willing to accept.

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CONCLUSIONS
We have gone through the methodology most frequently used by financial directors to decide where they should invest the money entrusted to them by their shareholders and bankers. We have tried to show that the accounting methods are imprecise because they dont take into account the way in which businesses generate money. Thus we have seen that the payback period can cause us to make incorrect decisions due to the fact that it forgets the money that a business activity can produce once the initial outlay has been recouped. Nevertheless, it has served as an opportunity for us to glimpse that investments with a long payback period can be dangerous as a result of the uncertainty that the fact that they produce income at a remote point in time can cause. The use of PV has introduced us to the enticing world of the valuation of financial assets. How much are the assets of which a business is made up worth? The money they are expected to produce, taking into account when they are going to produce it and the risk of their not doing so. When is a business venture good? When it is worth more than it costs, which is to say, when the present value of its cash flows is greater than what we would have to pay for the assets needed to start it up and run it. The NPV, which is nothing more than the difference between what an investment is worth and what it costs, serves to classify investments as recommendable when their NPV is positive or zero, because they are worth as much as or more than they cost, and to be rejected when their NPV is negative as they are worth less than they cost. IRR is obtained by particularizing the mathematical formula of the NPV and is used to judge investments in terms of comparative profitability. Those whose IRR is higher than the discount rate required by the investors are recommendable as they have a higher rate of return than that required by the investors. Those investments that have an IRR lower than the discount rate are to be rejected because they do not produce the rate of return desired by the investors who are to finance the project. It has also been noted that the PV, NPV and IRR are based on the implicit hypothesis that the cash flows are reinvested at the same rate as is being discounted. This generalization can lead us to undesirable results when the reinvestment is not expected to be possible at the desired rate of return.

11

This could be an increase in sales, a decrease in costs or a smaller investment in working capital.

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