INVESTMENT economics

Part 4: Investment
Efficiency
LEARNING GOALS

- To understand the various indicators of

profitability and return used in performance
evaluation;
- To be able to define and calculate each
indicator for any given project;
- To understand how these indicators affect
performance evaluation and investment
decisions.
STRUCTURE

4.1. Definitions
4.2. Measures without time-consideration
- Payback period (PP)
- Break-even point (BEP)
4.3. Measures with time-consideration
- Net Present Value (NPV)
- Profitability of Investment (PI)
- Internal rate of Return (IRR)
- Discounted Payback period (DPP)
 4.1. Definition
Vu, T. K. O. & Nguyen, T. V.
H, "The efficiency of an
investment activity or a project
is the difference between
benefits and costs."
- Private investors:
financial efficiency
- Society: economic &
social efficiency
 Measures
 Measures without time-
consideration/ Non-discounted
cash flow method
 Measures with time-consideration/
Discounted cash flow method
4.2. Non-discounted cash flow method

4.2.1 Payback period

4.2.2 Break even point
4.2.1 Payback period (PP)
Vu, T. K. O. and Nguyen, T. V. H, "Payback period of a
project is a duration of time which is just enough
for the total revenue to cover the total investment
of the whole project life cycle."
T n

 i  i
TR 
i 0
TC
i 0
 EXERCISE 1 (PP)
0 1 2 3 4 5
Preparation
Fixed asset -30
DWC -10
Execution
Revenue 50 50 50 50 50
Cost (depreciation included) -26 -26 -26 -26 -26
Depreciation 6 6 6 6 6
Tax -6 -6 -6 -6 -6
Difference in DWC 0 0 0 0 0
Closeout
Liquidation 0
Receiving from DWC 10
CF -40 24 24 24 24 34
If equally TR, using below formula:
n
t  C
i 0
i / TRi
PP: time required to recover the initial
cost of investment

Initial cost of Investment

PP 
Annual cash flow
 EXERCISE 2 (PP)
Year 0 1 2 3 4 5
Preparation
Fixed asset -60
DWC -20 -5 -5 2.5 2.5
Execution
Revenue 80 100 120 110 100
Cost (depreciation included) -76 -92 -108 -100 -92
Depreciation 12 12 12 12 12
Tax -0.8 -1.6 -2.4 -2 -1.6
Closeout
Liquidation 5
Receiving from DWC 25
Tax from liquidation -1
CF -80 10.2 13.4 24.1 22.5 47.4
If annual cash flow are not the same, using the formula
t
|  CFi |
PP  t  i 0
CFt 1
t: year nearly full recovery
 HOW TO USE PP?

• How long it will take for the investment to pay back

the initial cost?
• In project selection
- PP < target payback  accept

- PP > target payback  reject

• In alternative-projects selection
Choose the shortest PP
 EXERCISE 3 (PP)
Assume NEM company is deciding between two machines
(Machine A and Machine B) in order to add capacity to its
garment plant. The company estimates the cash flows for
each machine to be as follows:
Table3: Expected after-tax cash flows for the new
machines
Year 0 1 2 3 4 5
Machine A -5000 500 1000 1000 1500 2500
Machine B -2000 500 1350 1500 1500 1500

Calculate the PP of the two machines using the above cash

flows and decide which new machine NEM should accept.
Assume the target payback period the company establishes is
5 years.
 ANSWER 3 (PP)

PP of Machine A = 4 + 1000/2500 = 4.4 years

PP of Machine B = 2 + 150/1500 = 2.1 years
An investment project is expected to have a total investment of 30 million
USD, in which investment in fixed assets is 20 million USD. Fixed assets
are fully depreciated and fully depreciated in 10 years (this is the life of the
project). The project is expected to have an annual net profit of 6 million
USD. The loan interest is assumed to be 0.
1. Calculate the payback period of the project.
2. If there is a change in depreciation of fixed assets as follows (assuming
other factors remain constant):
USD 2 million is depreciated at the rate of 50% / year
USD 10 million is depreciated evenly and completely in 5 years
The remaining fixed assets are depreciated evenly and expire in 10 years.
the project's payback period has changed?
An investment project needs USD16,000,000. NP =USD 2,500,000 / year
Plan 1: 1,200,000 / year (depreciated and expired in 2 years)
Plan 2: 900,000 / year (depreciated and expired in 4 years)
Plan 3: 1,000,000 / year (depreciated and expired in 10 years of plan.)
Payback period calculation
PP: PROS AND CONS
 4.2.2 Break even point (BEP)
BEP is used to determine the point at which revenue received
equals the costs associated with receiving the revenue.
Vu T. K. O. and Nguyen T. V. H "Break even point is the point at
which total sales is just enough to cover total costs"

TR  TC
PQBEP  FC  VC  FC  vQBEP
FC
FC: fixed cost QBEP 
VC: variable cost
v: variable cost per unit Pv
 P TR

Gain TC

BEP
TR*=TC*

VC

FC
Loss

Q* Q
EXERCISE 1 (BEP)
Assume a company is deciding two options of
buying car for taxi business:
- Plan 1: Buy a new car with total investment
500mVND; v=6000VND/km;
Price=11000VND/km
- Plan 2: Buy a second-hand car with total
investment 240mVND; v=8000VND/km;
Price=11000VND/km
Calculate BEP of the two options and which
Plan that the company should accept
ANSWER 1 (BEP)
 FC 500,000,000 
QBEP1  P  v  11000  6000  100,000km
 

 FC 240,000,000 
QBEP 2  P  v  11000  8000  80,000km
 
Total Fixed cost: USD 1,350,000
Total Variable cost: USD 1,980,000
The above costs correspond to an annual output of 12,000 units. Inventory
is considered as 0. Selling price is USD300 / product.
1. Determine the company's breakeven point.
Q*=FC/P-v=1350000/(300-1980000/12000)1350000/(300-165)=10000
Total output: 12000, Q*: 10000
2. If the company expands production so that the annual fixed cost
increases by USD67,500 and the output increases by 4,000 products /
year, the break-even point will change? (Know that other factors remain
constant: selling price, variable cost / product)
Q*=(1350000+67500)/(300-165)=10500
Total output: 16000, Q*: 10500
3. Should the company expand production? Why?
4.3. With time-consideration
4.3.1. Net present value (NPV)
4.3.2 Profitability index (PI)
4.3.3. Internal rate of return (IRR)
4.3.4. Discounted Payback period (DPP)
 4.3.1. Net present value
A student is considering to study abroad for
undergraduate course during 4 years. Total of
enrollment fees 40,000USD paid in the first year.
After finishing the course, she expects to come back
Vietnam and work for an international company with
salary 400USD/month (=4800USD/year). Also the
salary expected to increase annual 25%.
After working for 6 years, she would quit the job, get
married to a rich gentleman and stay at home, enjoy
life. Is the investment efficient? r=8%
 Total of investment: 40,000USD
 Total of income:

4,800 + 6,000 + 7,500 + 9,380 + 11,730 +

14,660 = 54,070 USD
A dollar today is worth more than a dollar tomorrow.
PRESENT VALUE (PV) AND
FUTURE VALUE (FV)

FVn=PV(1+r)n

1
PV  FVn
(1  r) n
 r=8%/year
YEAR 1 2 3 4 5 6 Total

CASH 4800 6000 7500 9380 11,730 14,660 54,070

FLOWS

PV of 3,267 3,781 4,376 5,068 5,868 6,790 29,150

CFs
EXERCISE 1 (PV-FV)

A person puts 100m VND in bank with the different

interest rate:
- 8%/year in the first year and the second year.

- 9%/year during the next 3 years

- 11%/year during the last 4 years

Calculate FV9 and average interest rate.

 ANSWER 1 (PV-FV)

FV9=PV (1+r1)2(1+r2)3(1+r3)4
FV9=100m (1+8%) (1+9%) (1+11%)
2 3 4

= 100m(1+R)9
 Net present value
Vu, T. K. O. & Nguyen T. V.
H., ”The difference between
the present value of total
revenue and that of total
investment; or the present
value of total cash flow of the
project".
 n n
1 1
NPV   TRi   TC i
i 0 (1  r ) i 0
i
(1  r ) i

n
1
NPV   CFi
i 0 (1  r ) i
 NPV

CF1 CF2 CFn

NPV  CF0    ... 
(1  r ) (1  r ) 2
(1  r ) n

CF0: the initial investment

CF1,CF2..,CFn: cash inflow
 HOW TO USE NPV?

• Is project profitable?
• In project selection
- NPV>0  accept

- NPV<0  reject

• In alternative-projects selection
Choose the biggest NPV
 EXERCISE 1 (NPV)
Assume NEM company is deciding between two machines
(Machine A and Machine B) in order to add capacity to its
garment plant. The company estimates the cash flows for
each machine to be as follows:
Table3: Expected after-tax cash flows for the new
machines
Year 0 1 2 3 4 5
Machine A -5000 500 1000 1000 1500 2500
Machine B -2000 500 1350 1500 1500 1500

Calculate the NPV of the two machines using the above cash
flows and decide which new machine NEM should accept;
r=8%
 CF1 CF2 CFn
NPV  CF0    ... 
(1  r ) (1  r ) 2
(1  r ) n

NPV(A) = -81.8 < 0

NPV(B) = 2934 > 0
NPV: PROS AND CONS

• Use time value of money

• Use the timing of cash flows
• Target of profit

• Useless to compare with different

scale of projects
 EXERCISE 2 (NPV)

Year 0 1 2 3 4

Machine C -100 90 90

Machine D -150 70 70 70 70

Calculate the NPV of the two machines using the above cash
flows and decide which new machine the company should
accept; r=8%
 ANSWER 2 (NPV)

NPV(C) = 60.5
NPV(D) = 81.8
4.3.2. Profitability index (PI)

Vu, T. K. O. & Nguyen T. V. H.,

”the ratio between the present
value of total revenue and that
of total investment”.
 Profitability index
n
1
 TRi
(1  r ) i
NPV
PI  n
i 0
 1 n
1 1
i 0
TCi
(1  r ) i i 0
TCi
(1  r ) i
 HOW TO USE PI?

• Is project profitable?
• In project selection
- PI>1  accept

- PI<1  reject

• In alternative-projects selection
Choose the biggest PI
 EXERCISE 1 (PI)

Year 0 1 2 3 4

Machine C -100 90 90

Machine D -150 70 70 70 70

Calculate the PI of the two machines using the above cash

flows and decide which new machine the company should
accept; r=8%
4.3.4. Internal rate of return (IRR)

Vu, T. K. O. & Nguyen T. V. H.,

”the rate of return at which total
revenue is equal to total
investment”.
 4.3.3 Internal rate of return

n n
1 1
NPV   TRi   TC i  0
i 0 (1  IRR ) i 0
i
(1  IRR ) i

CF1 CF2 CFn

CF0    ...  0
(1  IRR) (1  IRR) 2
(1  IRR) n
 EXERCISE 1 (IRR)

Year 0 1 2 3

Machine C -100 90 90

Machine D -150 70 70 70

Calculate the IRR of the two machines using the above cash
flows and decide which new machine the company should
accept
 HOW TO USE IRR?

• Is project profitable?
• In project selection
- IRR>r  accept

- IRR<r  reject

• In alternative-projects selection
Choose the biggest IRR
IRR: PROS AND CONS

• Use time value of money

• Use the timing of cash flows
• Without r

• Useless to compare with different

scale and period of projects.
4. Discounted Payback period (DPP)

Vu, T. K. O. & Nguyen T. V. H.,

”the duration that the present
value of total revenue is just
enough to cover that of total
investment”
 4.3.4 DPP
T T
1 1

i 0
TRi
(1  r ) i
 i 0
TC i
(1  r ) i

t
1
CF0 -  CFi /
(1  r ) i
DPP  t  i 0
1
CFt 1 t 1
(1  r )
 EXERCISE 1 (DPP)
Year 0 1 2 3 4 5
Machine A -5000 500 1000 1000 1500 2500

Machine B -2000 500 1350 1500 1500 1500

Calculate the DPP of the two machines using the above cash
flows and decide which new machine NEM should accept.
Assume the target payback period the company establishes is
5 years; r=10%
 HOW TO USE DPP?

• How long it will take for the investment to pay back

the initial cost?
• In project selection
- DPP < target payback  accept

- DPP > target payback  reject

• In alternative-projects selection
Choose the shortest DPP
DPP: PROS AND CONS

• Use time value of money

• Use the timing of cash flows
• Better than using PP

• Unable to distinguish between the

same DPP of projects
• Not determine the profit of project
 Exercise 2 (combi)
Projects Initial Investment IRR NPV PI
A 500$ 18% 50$ 1.1
B 5000 25 6500 2.3
C 5000 37 5500 2.1
D 7500 20 5000 1.67
E 12500 26 500 1.04
F 15000 28 21000 2.40
G 17500 19 7500 1.43
H 25000 15 6000 1.24

Choose the best group with the investor’s

preference is as follows:
Choose the project

The investor’s preference:

- Capital: 10% (the smaller is the
better)
- IRR: 20%
- NPV: 50%
- PI: 20%
Pr
oje Captita Ran Rank Rank Rank
IRR NPV PI
ct l kC IRR NPV PI

A 500 1 18 7 50 8 1.1 7 4.4

B 5000 2 25 4 6500 3 2.3 2 3.4
C 5000 2 37 1 5500 5 2.1 3 4
D 7500 3 20 5 5000 6 1.67 4 5.6
E 12500 4 26 3 500 7 1.04 8 6.6
F 15000 5 28 2 21000 1 2.4 1 1.6
G 17500 6 19 6 7500 2 1.43 5 3.8
H 25000 7 15 8 6000 4 1.24 6 6
Project selection
There are 3 available projects:
Questions:
1. Calculate NPV, IRR, PI và DPP of 3 projects?
2. Please advise the investor which project to choose?

Năm 0 1 2 3 4 5 6 7 8
Dự án A - 1,000.00 505.00 505.00 505.00
Dự án B - 10,000.00 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 12,000.00
Dự án C - 11,000.00 2,650.00 2,650.00 2,650.00 2,650.00 2,650.00 2,650.00 2,650.00 2,650.00

62
Project selection

NPV C (1000
IRR PI T (năm) n (năm)
(1000 USD)
A 255.86 24.04% 1.26 2.33 1,000.00 3

B 5,334.93 20.00% 1.53 7.05 10,000.00 8

C 3,137.55 17.43% 1.29 5.64 11,000.00 8

63
PV-FV Exercises

Interest rate conversion:

Ms. A borrowed from Mr. B 30,000,000 VND, interest rate 12% / year, monthly
compounded interest rate. What is the amount earned by Mr. B after 3 years and 4
months of lending?
A financial investor invests 300 million at the beginning of the first year, then invest
100 million in the next 3 years, invest 120 million after the next 2 years. How long
will it take to have a total amount of 953 million, r = 6%
Future value of annuity

The project needs 200,000 USD, divided into 10 equal investments in 10 years,
starting from year 1. After 10 years, it is expected that the total amount of capital and
interest will be 250,000 USD.

 Should the businesses invest? The bank interest rate of 8% / year, the
compounding period is 1 year.
 A A A A A

YEAR 1 2 3 4 5

FVn =A(1+r)0 + A(1+r)1 + A(1+r)2 +...+ A(1+r)n-1 (*)

 Multiply (*) with (1+r):
 FVn (1+r) =A(1+r)1 + A(1+r)2 + A(1+r)3 +...+ A(1+r)n (**)
 (**) minus (*):
 FVn(1+r) – FVn = A (1+r)n – A
 <=> FVn x r = A [(1+r)n-1]
 Finally we have:

(1  r)  1 n
FVn  A
r
 Mr. A continuously deposited 2 million dong
each month in the bank, interest rate 1% /
month (monthly compounded interest). After
the 14th deposit, Mr. A does not deposit or
withdraw any money. 5 years after the last
time he deposited money to the bank, he
comes to withdraw money. Calculate the
total amount that Mr. A receives?
Present value of annuity

 A customer can choose to buy a car with the

following options:
- Pay after 1 year for 60,000 USD
- Installment payment for 5 years at the amount
of 15,000 USD / year
 The interest rate is r = 10% / year

 Please advise him which purchase option

should he choose?
 A A A A A

0 1 2 3 4 5

 We have: 1
PV  FVn
(1  r) n

 and, (1  r) n  1
FVn  A
r

-> Finally:
(1  r) n  1
PV  A
r(1  r) n
Company A wants to choose 1 out of 2 different machines with the same function.
If the Company buys the cheaper machine, the company will save 10 million dong
at buying, but later, the annual operating cost is 3.33 million dong higher than the
other’s cost over the life of the machine which is 5 years.
 Which machine should the company buy? r = 10% / year
ABC Company offers the sales policy as follows:
- The customer does not have to pay at the moment of buying. One year
after that, the customer has to pay 110 million/year, continuously for 10
years.
- Factory X wants to buy but offers to pay the total amount of 1,100 million
once at the end of the 5th year from the date of buying.
r = 18%

 Does ABC company agree to sell? If ABC still wants to sell to X, when
will X have to pay the amount of 1,100 million?
Mr. Hoang is a real estate investor, recently bought a house and is
planning to use it in the most economical way. There are 3 different ways
as follows:
1. Sell the house right away for USD 30,000
2. Installment sale at the annual interest rate of 15% for 5 years at the
price of 8,000 USD / year
3. Lease indefinitely at the annual price of USD 2,000, interest rate 15%

 Please help Mr. Hoang choose the best option?

Company X wants to purchase a system from Japan. The company
received the following offers:
Option 1: CIF price at HP port, total payment amount is USD100,000.
Payment method is: 20% of the total amount is paid one year after
delivery; 30% in next year; 50% in next year.
Option 2: CIF price at HP port USD100,000. Payment in 4 years:
25%/year; The first payment is 1 year after delivery
Option 3: CIF price at HP port USD100,000. Payment in 5 times, every
year: 20%/each payment, the first payment is immediately upon delivery
Option 4: CIF price of HP port at 87,000 USD. Payment on delivery.

 Choose the most profitable offer for company X. Interest rate is 13% /
year.
Mr. A is in need of a large amount of money, so he rents the villa for 5
years under one of two options:
Option 1: the annual rental amount is 115 million / year, the first payment
is right at renting. At the same time, the customer has to deposit 200
million. This amount is refunded at the end of the lease.
Option2: The customer only pays one time for the total amount of 500
million dong (no deposit) right at renting.
R = 12% / year

 Mr. John wants to rent this villa. Please advise Mr. John which option to
choose?
 An investor plans to invest in a project with the following financial information:
Investing in fixed assets is USD80 million (one-time expense when
implementing the project). Fixed assets are depreciated evenly and expired in 8
years. The life of the project is 6 years. By the end of year 6, the fixed assets
will be liquidated at the price of USD15 million. The estimated annual revenue
is as follows: (unit: USD million)

Year 0 1 2 3 4 5 6
Revenue 80.00 90.00 100.00 110.00 90.00 70.00

Total annual production cost (including depreciation cost) is equal to 90%

of revenue. The corporate income tax rate is 25%. The demand for
working capital is 10% of revenue and must be prepared from the
previous year. The rate of return required by the investor is 11%.
Question:
1. Calculate the payback period of the project
2. NPV =?
3. PI?
4. Total investment capital?
Year 0 1 2 3 4 5 6
Fixed asset -80
DWC -8 -9 -10 -11 -9 -7
DWC Changes -8 -1 -1 -1 2 2
Revenue 80 90 100 110 90 70
Total cost -72 -81 -90 -99 -81 -63
Depreciation 10 10 10 10 10 10
Tax -2 -2.3 -2.5 -2.75 -2.25 -1.75
Receiving from DWC 7
Liquidation 15
Tax from Liquidation 1.25
CF -88.00 15.00 15.75 16.50 20.25 18.75 38.50
An investor plans to invest in a project with the following financial
information:
Total investment capital is USD100 million in which investment
capital for fixed assets is USD 80 million (one-time payment when
implementing the project). Fixed assets are depreciated evenly and
expired in 8 years. The life of the project is 10 years.
By the end of year 10, the fixed assets will be liquidated at a price of
$ 2 million. Estimated annual turnover is 150 million USD. Total
annual production cost (excluding depreciation cost) is equal to 85%
of revenue. The corporate income tax rate is 20%. The required rate
of return is 12%.
Question:
Make a project's cash flow table.
Advise the investor whether to invest in this project and state the
reason?
Year 0 1 2 3 4 5 6 7 8 9 10
Fixed asset -80
DWC -20
Revenue 150 150 150 150 150 150 150 150 150 150
-
Total cost 137.5 -137.5 -137.5 -137.5 -137.5 -137.5 -137.5 -137.5 -127.5 -127.5
Depreciation 10 10 10 10 10 10 10 10 0 0
Tax -2.5 -2.5 -2.5 -2.5 -2.5 -2.5 -2.5 -2.5 -4.5 -4.5
Receiving from
DWC 20
Liquidation 2
Tax from
liquidation -0.4
-
CF 100.00 20.00 20.00 20.00 79
20.00 20.00 20.00 20.00 20.00 18.00 39.60
 Exercise 3 (combi)
- Total estimated investment: 120, in which
+ Fixed asset: 84 (paid all in 1 time in the
preparation pe., equally depreciated in 8 years)
+ The rest is for demanded working capital
- Estimated operation time is 6 years.
- In closeout, fixed assets are liquidated at 22.
- Annual revenue: 120, annual cost (depreciation
included): 105
- Corporate income tax rate: 25%, Min require rate
of return:11%
 Exercise 4
1. Set up CF table
2. Calculate financial indexs with time
consideration of the project
3. Should the investor carry out this
project?
 Exercise 3(combi)
Note:
Operation < Depreciation \
 the remained value of the fixed
assets
Tax from:
The remained value - Liquidation
 EXERCISE 3 (COMBI)
Year 0 1 2 3 4 5 6
Preparation
Fixed asset
DWC
Execution
Revenue
Cost (depreciation
included)
Depreciation
Tax
Closeout
Liquidation
Receiving from DWC
Tax from liquidation
CF
 EXERCISE 3 (COMBI)
Year 0 1 2 3 4 5 6
Preparation
Fixed asset -84
DWC -36
Execution
Revenue 120 120 120 120 120 120
Cost (depreciation -105 -105 -105 -105 -105 -105
included)
Depreciation 10.5 10.5 10.5 10.5 10.5 10.5
Tax -3.75 -3.75 -3.75 -3.75 -3.75 -3.75
Closeout
Liquidation 22
Receiving from DWC 36
Tax from liquidation -0.25
CF -120 21.75 21.75 21.75 21.75 21.75 77.5
 ANSWER 3 (COMBI)

NPV=1.82
PI=1.01
IRR=11.43%
PP=5.14 years
DPP=5.95 years
 EXERCISE 4 (COMBI)

Choose the best project, r=10%

Year 0 1 2 3 4 5 6 7 8

Project A -1000 505 505 505

Project B -10,000 2000 2000 2000 2000 2000 2000 2000 12000

Project C -11,000 2650 2650 2650 702650 2650 2650 2650 2650
 ANSWER 4 (COMBI)
Year II NPV PI IRR DPP

Project A -1,000 255.86 1.26 24.04% 2.33

Project B -10,000 5,334 1.53 20% 7.05

Machine D -11,000 3,137 1.29 17.43% 5.64

 RANKING PROJECTS

Year II NPV PI IRR DPP Score

Project A -1,000 255.86 1.26 24.04 2.33 (1) 8

(3) (3) % (1)
Project B -10,000 5,334 1.53 20% 7.05 (3) 7
(1) (1) (2)
Machine D -11,000 3,137 1.29 17.43 5.64 (2) 9
(2) (2) % (3)
 Year II NPV PI IRR DPP

Project A -1,000 3 3 1 1

Project B -10,000 1 1 2 3

Machine D -11,000 2 2 3 2
 EXERCISE 5

Year 0 1 2 3

Project M -120 100 25 25

Project N -110 25 25 100

1) Compute NPV, r=10%

2) Calculate r1 that at which NPV(M) = NPV(N)