2-Investment Decision Analysis

Investment Decision Analysis

Management must make basically three types of investment

decisions:1) A go or no go decision for single project, 2) Selection of
one project from many exclusive projects and 3) Selection of
portfolio of projects from numerous possibilities.
This chapter concentrates on:
 Types of Decisions
 The attributes of an ideal yardstick for measuring investment worth.
 Description of some of the investment yardsticks currently in use.

But now let us discuss some basic concepts and also the time
value of money before examining the different projects scenarios

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Basic Concepts

 Primary step in any project is to answer the question

is it profitable?
 Let us define profit as:
Profit = Revenues – Costs
 There are three models to determine profit: Cash
Flow, Financial and Tax). Each model has a different
way of defining costs, results in a different calculated
value of profits.

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 Cash Flow Model
 In cash flow model, the profit is the net cash flow (NCF).
 In cash flow model, revenues are recognized when the cash is received
and costs are recognized when the cash is paid out.

 Flow Chart to calculate net cash flow AFIT

Your share of gross revenue
- your share of direct cost
= net operating income BFIT
– income taxes
= net operating income AFIT
– investments
= net cash flow AFIT

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Figure illustrates the net cash flow for each period that
assumed to be received at the end of each period.

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 Financial Model
 In financial model, recognition of revenues and expenses for the
determination of financial net income can be on a cash basis, modified
cash basis, or an accrual basis.
 Small firms typically use a modified cash flow, large firms usually use the
accrual method of accounting.
 Depreciation“D”: is the systematic expensing of the cost of a tangible
asset over assumed life of asset.
 Depletion “D”: is the systematic expensing of the asset value of a
natural resources over the assumed life of the asset.
 Amortization “A”: is the systematic expensing of an intangible asset
over the assumed life of the asset
Flow chart for calculating Financial net income:
Your share of gross revenue – your share of direct costs – DD&A – Income
taxes = Financial net income AFIT
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 Figures 1 and 2 demonstrate
the accrual concept for
revenues and direct costs

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 Figure 1-5 compares the
treatment of capital
expenditures in the cash flow
model with the treatment
used in the financial model

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 Tax Model
 In this model, the internal revenue service (IRS) sets (and then
changes) the rules of calculation of a profit. The IRS recognizes that a
portion of the revenue from property represents the return of the
increased capital and that a portion of the revenue represents rents or
income generated by that capital.
 Depreciation, depletion and amortization “DD&A” are also used in the
tax model but calculated in way different from financial model.
Flow chart for calculating taxable income:
Your share of gross revenue – your share of direct costs – allocated
overhead – expensed intangible project costs – DD&A = Taxable
income
Which model is the best? For Economic analysis the answer is simple-
always use the cash flow model. The reason lies in the time value of
money concept.
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Which Model is The Best
 For economic answer, the cash flow model is
recommended. One $ today is better than one $
dollar after 5 years
 Other models distort the timing of the flow of funds
and from the project

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Time Value of Money
 Money has a time value. That means that a Dollar
received today has more value to us than a dollar
received in the future.
 Interest is the best mechanism to handle the
operation: It is the amount of money which must be
added to our current sum to make an equivalent
future sum.
 Interest rate is the amount of interest per period
divided by the principle amount at the beginning of
the period.

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Cash Flow Diagram
 One of the most helpful techniques for unraveling
complicated interest rate problems is the technique
of using cash flow diagrams.
 A cash flow diagram is a graphical representation
showing when the cash flows into and out of a
project.
 Sometimes money paid or invested at time 0 or is
paid out and received at the same time.

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Interest Rates
Simple Interest Rate
 Simple interest rate is a concept is seldom used for

periods greater than one year.

F = P (1+in) where n = m*t
Compound Interest Rate
 For loans or bank deposits which exceed one year,
the interest is usually compounded. , that is the
interest earned during the first period is added to the
original principal in order to form the principal for the
second period.

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 The compound interest concept will be used
when calculating the equivalence between a sum
of money today and future sums of money.
 Future Worth of a Lump Sum
The future worth of a present value sum P earning
compound interest can be derived by applying the
simple interest formula over and over again.
Fn = P (1+ i)n
 Present Worth of Lump Sum
This is by far the most important equation, by this
equation and using the time diagrams, any compound
interest can be solved.
P = F / (1+i)n

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 Sinking Fund
 Rather than a lump sum, a sinking fun involves a series of
equal payments (A) deposited at the end of each
compound period.
This concept is often referred to as a uniform periodic
series. The formula relating these terms is:
A = F[ i / ((1+i)n – 1)]
The factor [ i / ((1+i)n – 1)] is called the sinking fund factor

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Annuity
In an annuity, a present P is exchanged for a
uniform series of end-of-period amounts A spread
over n periods
The equation relating these factors is:
A = P[(i /((1+i)n -1) + i]
The factor (i /((1+i)n -1) is often called the capital
recovery factor. Notice that it is the sinking factor
plus the interest rate

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Annuity – Due or Lease
A lease or annuity due is the same as a regular
annuity, except that the payments are due at the
beginning of the period. The equation relating B and
B is:
B = P[(i /((1+i)n -1)*( 1+i)n-1]

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Modified Sinking Fund

Often, when money, the payments are made at the

beginning of the period instead of the end. This is
called modified sinking fund. The relationship
between B and F is:
B = F[ i / ((1+i)n – 1)/(1+i)]

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Rule of 72

The rule of 72 is an approximation used to determine

how long it takes to double your money. If money
can be invested at i% per period, then it takes 72/ I
periods to double, or in equation form,
i*n = 72

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Rule of 78
The rule of 78 is often used to calculate the amount
of interest that is due if a loan is paid off before the
end of its term.
It can also used to calculate the amount of refund
that is due if a prepaid insurance policy is cancelled
before the end of term.
The rule 78 can be applied to year term or to term
other than year. The lenders strive to include the rule
of 78 in the loan agreement.
Table 2-3 Prepayment of one year note using Rule of 78

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 RULE OF 78 \
The rule of 78 is often used to calculate the
amount of interest that is due if a loan is paid off

Table 2-3
Prepayment of one year note
using Rule of 78

Payoff occurs Fraction Prepayment Multiplier to

at end of of Factor Convert Stated
Month Interest Loan Int. Rate to

''Earned'' True Int. Rat s::

1 12/78 I+ .154i 1.85.,_

2 (12+ 11)/78 1+ .295i 1.77
3 (12+ l I+ 10)/78 1+ .423i 1.69
4 42/78 1+ .538i 1.62
5 50/78 1+ .641i 1.54
6 51/78 I+ .731i 1°.46""
7 63/78 , 1+ .808i 1.38
8 68/78 1+ .872i 1.31
9 72/78 1 + .923i 1.23
10 75/78 1+ .962i 1.15
11 77/78 1+ .987i 1.08.
12 78/78 1+ l.OOOi 1.00
"-
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Compound Interest Eqs. and Cash Flow Patterns

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 Types of Decisions
 Single Project: The first test that any project must pass is
the “Go or No-Go” criteria established by management.
That is, each project must be able to stand alone.
Incremental analysis, the key to every investment decision;
(This analysis shows the true effect of doing a project, the projected
cash flows for the company without the project should be subtracted
from the projected cash flows of the company with the project)
 In making decision the go or no-go for a single project,
management usually calculates several yardsticks to
measure profitability. Typically the final decision is not
based on a single attribute, it is mainly good mangement
decision.
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 Types of Decisions
 Mutually Exclusive Projects: Mutually exclusive projects
are two or more projects where the acceptance of one
means the rejection of all others.
1. All considered projects must pass go or no-go criteria.
2. Each acceptable project is then compared to other
remaining projects and incremental analysis is applied.
3. In cases of more than two projects, the project surviving
the comparison is then compared to one of the remaining
projects. This process is continued until only one project
remains.

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 Types of Decisions
 Portfolio of Projects: The selection of a portfolio of
projects from numerous possible projects is the decision
process during capital budget deliberations.
 If capital is unlimited, all projects meeting the minimum
requirements for single project selection.
 Ordinary, capital constraints require some projects must
be rejected. The suite of projects that gives the best
combined value must be selected by management.
 This is done by considering the yardsticks or measures of
investment worth of each decision.

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 Attributes of an Ideal Yardsticks
Since management must constantly make decisions,
yardsticks or measures of investment worth are used to
help compare or rank competing projects.
List of Ideal Yardsticks
1. Consistent with corporate goal
2. Easy to understand and apply
3. Permits cost effective decision making
4. Provides a quantitative measure for acceptance or rejection
5. Permits alternatives to be compared and ranked
6. Incorporates the time value of money

Yardstick must help management quantify the decision process.

There are two general categories of measures of investment
worth: 1) Yardsticks that ignore the time value of money and 2)
Yardsticks that incorporate the time value of money.

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 Yardsticks That Ignore Time
Value of Money
 Yardsticks that ignore time value of money
have five decision models:
1. Urgency
2. Payback
3. Bail-Out Factor
4. Accounting Rate of Return
ARR = NI/((I-S)/2)
5. discounted Profit to Investment Ratio

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Payback or payout is a measure of the time required to return the original
investment

Bail-Out Factor is similar to payback: it is occurred at a time when the

NCF and salvage values equal to the original investment

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Profit/ Investment is calculated either by dividing the net cash
flow of the project or net operating income by the investment

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 Yardsticks That Incorporate
Time Value of Money

 Yardsticks that incorporate the time value of

money have following features:
1. Net Present Value
2. Present Value Profile
3. Discounted Profit to Investment Ratio
4. Discounted Cash Flow Rate of Return
(DCFROR)

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Net Present value(NPV) is calculated by discounting the future
net cash flows to time zero and summing them

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Treasury will grow at the fastest rate, only projects having a
positive net present value when discounted at the company’s
average investment opportunity

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Given that only projects A,B,C and “Average” projects are available and that
our goal is treasury growth, we would prefer projects A,B and a 5000$
average project. This combination results in the largest possible sum in the
treasury at the end of 4 years.

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Present value profile is generated by calculating the NPV for each project at
several discount rates. The plot of NPV vs. discount rate is then made. From
the present value profile, the decision maker can determine the best project.

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The DCFROR is the primary measure of investment worth for many firms, it is
widely used since the yardstick relatively easy to use: it does not require that
a discount rate be established prior to making the calculation.

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The real question is what one do in the case where multiple rates of return
are calculated. One approach is to use the NPV profile plot. Following
example presents the results of the net present value calculations for various
discount rates.

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Net present values for projects A, B and C for the infill drilling program are
plotted in the figure. If the average investment rate is between 15% and
150%, you would accept the project. Otherwise, the project is rejected.

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The modified DCFROR is calculated by discounting all investments to time 0.0
at the average company investment opportunity rate. Following example
shows the difference between modified DCFROR and traditional DCFROR

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It is important to understand the limitation inherent in each yardstick before
a yardstick is used to make an investment decision. Following table presents
the cash flow analysis for seven projects.

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 Which Yardstick is Best?
 The answer is: The best method is the cost effective
decision making. In a given situation, it is hard to
define precisely the method which will give the most
cost effective decision . This dilemma is encountered
either for single projects or mutually exclusive projects
or portfolio projects.
 Assuming that the corporate goal is treasury growth,
pick the projects that yield the greatest combined with
the appreciation of equity rate of return (AOEROR)
which incorporates the concept that the firm’s objective
is treasury growth.

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