Investment analysis

Lecture 6
 DISCOUNTED PAYBACK PERIOD

The discounted payback period is the time needed to pay back the original
investment in terms of discounted future cash flows.

Each cash flow is discounted back to the beginning of the investment

at a rate that reflects both the time value of money and the
uncertainty of the future cash flows.

Discounted payback cannot provide us any information about how

profitable an investment is — because it ignores everything after the
“break-even” point

The discounted payback period can be used as an initial screening device

— eliminating any projects that don’t pay back over the expected term of
the investment.
 DPP
• DPP= year, preceding year full compensation + discounted unreimbursed
part of costs / discounted cash flow in the year of compensation

Example
0 -1000 -100- -1000 PP= 2+100/300=2,33 years
1 500 500/1,1=455 -545 DPP=2+214/225=2,95

2 400 400/1,1^2=331 -214

3 300 300/1,1^3=225 11
4 100 100/1,1^4=68 79
how long should a project take to be accepted in terms of positive
NPV

the cash flows of the investment decision must recoup the

investment within the normative value

the lower the discounted payback period is, the better

 Standard payback period

Expert estimates: the longer the life of the project assets, the higher the
standard payback period. The more expensive the money in the market,
the shorter the payback period

Gordon's formula: Standard term is a function of the value of money

in the market, investment risk and the life of the project
! !
Tn= +
" "∗(!%")^(

P/E
 Net Present Value Technique

Net Present Value = Present value of all expected cash flows

Net Present Value

= Present value of the change in operating cash flows
+ Present value of the investment cash flows

“Net” is the difference between the change in the operating cash flows and the
investment cash flows causing the change in the firm’s operating cash flows.

A positive net present value means that the investment increases the value of the firm —
the return is more that sufficient to compensate for the required return of the
investment. A negative net present value means that the investment decreases the value
of the firm — the return is less than the cost of capital.

Because the net present value is a measure of how much owners’ wealth is expected to increase
with an investment, NPV can help us identify projects that maximize owners’ wealth.
 At a cost of capital of 10%, the net present value of project S would be $
78.82:

0 DCF 1 2 3 4

NCF –1,000 =-1000/1,10 500 400 300 100

454.55 =500/1,11

330.58 =400/1,12

225.39 =300/1,13

68.30 =100/1,14

NPV 78.82
THE INVESTMENT PROFILE
 Profitability Index Technique

The profitability index (PI) is the ratio of the present value of change in
operating

Instead of the difference between the two present values, as in the net
present value (NPV) calculation, PI is the ratio of the two present values.
Hence, PI is a variation of NPV. By construction, if the NPV is zero, PI is one.

DPI= Present value of the change in operating cash inflows/ Present value of
the investment cash outflows
DPI= 1+ NPV/ Present value of the investment cash outflows
 PI
0 DCF 1 2 3 4

NCF –1,000 =-1000/1,10 500 400 300 100

454.55 =500/1,11

330.58 =400/1,12

225.39 =300/1,13

68.30 =100/1,14

PI
=(454,55+330,58+225,39+68,3)/1000= (78,82+1000)/1000=1, 079
For each ruble invested, we receive an additional 0,08
Is the Profitability Index Consistent with
Owners’ Wealth Maximization?
If there is a limit on how much we can spend on capital projects, PI is useful. Limiting the
capital budget is referred to as capital rationing.

If there is a limit of $20,000 on what we can spend, which project or group of projects are
best in terms of maximizing owners’ wealth? If we base our choice on NPV, choosing the
projects with the high- est NPV, we would choose Z, whose NPV is $8,000. If we base our
choice on PI, we would choose projects X and Y — those with the highest PI — providing
a NPV of $6,000 + 5,000 = $11,000.

Our goal in selecting projects when the capital budget is lim- ited is to select those
projects that provide the highest total NPV, given our constrained budget. We could use
NPV to select projects, but we cannot rank projects on the basis of NPV and always get
the greatest value for our investment.
 Internal Rate of Return Technique
• An investment’s internal rate of return (IRR) is the discount rate that makes the
present value of all expected future cash flows equal to zero; or, in other words,
the IRR is the discount rate that causes NPV to equal $0.
• The decision rule for the internal rate of return is to invest in a project if it provides
a return greater than the cost of capital. The cost of capital, in the context of the
IRR, is a hurdle rate — the minimum acceptable rate of return.
 restrictions in use IRR
Plurality of root of the equation, lack of root of the equation, complexity of
interpretation

Reinvestment problem

The problem of ranking projects of different sizes

Not all projects have a decrease in NPV with an increase in the discount rate
(for example, a project to provide a loan)

the project can have several values, for example, if you need to reinvest

selection of the wrong project is possible when comparing mutually exclusive

projects

existence of multiple interest rates for a project

.
 Calculations

• Choose [r1;r2]-----NPV (r1)>0 NPV (r2)<0

• calculate NPV (r1) и NPV (r2)

NPV(r1)
IRR = r1 + * (r 2 - r1)
NPV (r1) - NPV (r 2)
• _____________________________________________
• For our example [10%; 15%]
• NPV (10%)=78,82 и NPV (15%)==-8,33
• IRR=10%+[78,82/(78,82+8,33)]*5%=14,5%
The IRR and Mutually Exclusive Projects
 IRR---NPV

NPV assumes cash flows are reinvested at the cost of capital.

• IRR assumes cash flows are reinvested at the internal rate of return.

This reinvestment assumption lead to different decisions in choosing

among mutually exclusive projects when any of the following factors apply:

The timing of the cash flows is different among the projects

There are scale differences (that is, very different cash flow amounts)

The projects have different useful lives

MULTIPLE INTERNAL RATES OF RETURN

The typical project usually involves only one large negative cash flow initially,
followed by a series of future positive flows. But that’s not always the case. Suppose
you are involved in a project that uses environmentally sensitive chemicals. It may
cost you a great deal to dispose of them, which will cause a negative cash flow at the
end of the project.

One possible solution is IRR = 10%. Yet another possible solution is IRR = 2.65, or
265%. Therefore, there are two possible solutions, IRR = 10% per year and IRR =
265% per year.
Modified Internal Rate of Return Technique

Step 1: Calculate the present value of all cash outflows, using the reinvestment rate as the
discount rate

Step 2: Calculate the future value of all cash inflows reinvested at some rate

Step 3: Solve for rate — the MIRR — that causes future value of cash inflows to equal
present value of outflows

The modified internal rate of return is a return on the investment, assuming a particular
return on the reinvestment of cash flows. As long as the MIRR is greater than the cost of
capital (that is, MIRR > cost of capital) the project should be accepted. If the MIRR is less
than the cost of capital, the project does not provide a return com- mensurate with the
amount of risk of the project.

MIRR can be used to evaluate whether to invest in independent projects and identify the ones
that maximize owners’ wealth. How- ever, decisions made using MIRR are not consistent with
maximizing wealth when selecting among mutually exclusive projects or when there is capital
rationing.
 DCF 1 2 3 4

NCF =-1000/1,10 500 400 300 100

=500*1,1^(4-1)

=400* 1,1 (4-2)

=300*1,1 (4-3)

=100*1,1(4-4)

MIRR 1000= 1576/ (1+MIRR)^4

MIRR= 12,1 % > 10%