III/ Project interaction

1. Mutual Exclusive Projects

Net present value
and other
investment criteria
2. Long- versus Short-lived equipment
3. Replacing an old machine
IV/ Capital Rationing
1. Soft Rationing
2. Hard Rationing
V/ Exercises

Outline
I/ Net Present Value
1. Overview of Net Present Value
2. Valuing long-lived projects NET PRESENT
II/ Other Investment Criteria VALUE
1. Internal Rate of Return
2. Payback
3. Book Rate of Return
 Net Present Value - Formula

Net Present Value (NPV) is a

Overview of Net formula used to determine the
present value of an investment by
Present Value the discounted sum of all cash
flows received from the project.

Net Present Value - Definition Net Present Value - Formula

The formula for the discounted sum of all
• Net Present Value (NPV) is the cash flows can be rewritten as:
difference between the present value of T
the future cash inflows from an Ct
NPV = – C0
investment and the amount of 1+r t
investment. t=1
In which
• Present value of the expected cash flows • Ct = net cash inflow during the period t
is computed by discounting them at the
• C0 = total initial investment costs
required rate of return.
• r = discount rate, and
• t = number of time periods
 Net Present Value - Formula
The formula for NPV is also:

NPV = –C0 +
C1
+
C2
+ … +
CT 1. A COMMENT ON
1+r 1+r 2 1+r T
RISK AND
–C0 = Initial Investment PRESENT VALUE
C = Cash Flow
r = Discount Rate
T = Time

Net Present Value – Example 1 Present Value – Definition

Consider company Shoes For You's who is
determining whether they should invest in a new • Present value describes how much a future
project. Shoes for You's will expect to invest sum of money is worth today.
$500,000 for the development of their new product.
The company estimates that the first year cash flow
• The formula for present value is:
will be $200,000, the second year cash flow will be CF
PV =
$300,000, and the third year cash flow to be 1+r n
$200,000. The expected return of 10% is used as the • Where:
discount rate.
CF = cash flow in future period
r = discount rate
n = number of periods
 Present Value – Example 1
Assume that you would like to put money in
an account today to make sure your child has
enough money in 10 years to buy a car. If you
would like to give your child $10,000 in 10
years, and you know you can get 5% interest
per year from a savings accounts during that
time, how much should you put in the
account now?
1.1 A comment on risks and
present value
• Time value of money needs to
be considered in every financial
analysis that cover more than one
period.
• A basic principle: A risky dollar is
worth less than a safe one.

Present Value – Example 2 Risk and present value

A company is considering construction of an
office block. Government Office
How much would the company have to invest securities developments
in this project in order to receive $400,000
when they sell this office block at the end of Stock market
next 3 year? investments
Support the loan offers interest of 10%.

⟹ Basic financial principle:

“A risky dollar is worth less than a safe one”
 Risks and present value - Example 1.1 A comment on risks and
❖Example 1: Invest $100 today to get $120 a year present value
from now Back to the above example: Assume the discount
rate is 6% and we have
• To make right investment choice, you should need
to know what is today’s value of these future $120 CF $120
PV = = = $113,2
& then compared with today’s investment of $100. 1+r n 1 + 0.06
• Today’s value of cash flow is called the present
value (PV). The PV of this example must be less Compare this PV with today investment of $100 =>
than $120 since today you could invest the money NPV is subtracted today’s investment from the PV:

to start earning interest immediately. NPV = $113 – $100 = $13

1.1 A comment on risks and Present value of a multiple

present value cash flow
• The present value of a delayed cash year
flow can be found by multiplying cash 1
flow by a discount factor which PV = CFt x
(1 + r)t
expressed as the reciprocal of 1 plus a
rate of return Cash flow
in year t
The
1 opportunity
Discount factor =
1+r cost of
capital
 Present value of a multiple
Present value of perpetuities
cash flow - Example 2:
❖Formula
• Company A has a multiple cash flow
Cash payment
project with CF1 = $300; CF2 = $400; interest present
from = rate x value
CF3= $500; CF4 = $400; r = 10%. perpetuity
Calculate the present value of this project. = r x PV

C cash payment
PV = =
r interest rate

Present value of perpetuities -

Present value of perpetuities
Example
Suppose you invest $100m at the interest rate
• Perpetuities are the payment
of 10%. You would earn annual interest of 0,1
streams lasting forever x 100 = $10m/year and could withdraw this
amount from your investment account each
year without ever running down your balance
⟶ $100m investment could provide a
perpetuity of $10m/year
 Present value of annuities Opportunity cost of capital

• Annuities are the payment streams The rate r used to discount cash
equal cash flow flow is the “opportunity cost of
1 1 capital”
Annuity factor = –
r r. 1 + r t
The reason is that it is the return
• PV = Cash flow x annuity factor that is being given up by
1 1 investing in the project
PV = C –
r r. 1 + r t

Present value of annuities Opportunity cost of capital

• Example: you borrow a mount of money
to buy a new car. You will pay off the loan
quickly by making 5 equal annual payment
of $50 million. If the interest rate is 18%,
what will the PV of the loan be?
• Cost of this project (in textbook):
- Land: $50,000
- Construction: $300,000
⟹ Total cost: $300,000 + $50,000 = $350,000
⟹ The amount of money that company would
actually have after selling office block:
PV = $400,000/(1 + 0.07) = $373,832
NPV = $373,832 – $350,000 = $23,832
 In this case, $23.832 is called Net A comment on risk and
present value (NPV) present value

NPV = PV – initial investment • A risky dollar is worth less than a safe

one.
The rule: Managers increase • Most investors avoid risk when they
shareholder’s wealth by accepting all
can do so without sacrificing return.
projects that are worth more than they
cost => accepting all projects with a • Not all investment are equally risky.
positive NPV ( NPV > 0)

In conclusion: A comment
on risk and present value
•We never be certain about the future
value of something.
•Future is something that we can’t know
Valuing Long-lived
exactly. All future value of something is Projects
just a forecast. => Future cash flows are
uncertain and some are more certain than
others.
 Valuing Long-lived projects -
Valuing Long-lived projects
Project assessment
• According to NPV method, all the future
• NPV < 0: The project is removed
cash payments of a long-lived project was
• NPV = 0: Depends on special situation
discounted to find their present value.
and the necessary of project that
• Discount rate which was used in
business can decide to accept or reject
calculating NPV of projects, usually is
project.
opportunity cost of capital (profitability
• NPV > 0: The project is accepted.
rate that investors required).

Valuing Long-lived projects Valuing Long-lived projects -

Steps to calculate NPVs
n
Ci
NPV = – C0 • Forecast the future project cash flows,
(1 + r)i noting when the flow occurs.
i=1
• NPV: Net present value of long-lived project • Estimate the opportunity cost of capital.
• Ci: Net cash flow of project in i year The opportunity cost of capital is
• C0: initial investment capital of the project the expected rate of return given up by
• n: life of project investing in the project under review.
• r: discount rate
 Valuing Long-lived Projects - Valuing Long-lived Projects
Example – Example solution
Mr. A have an office block which has the total cost • C1 = $16,000: 1st year cash flow
for land and construction is $ 350,000. A possible • C2 = $16,000: 2nd year cash flow
tenant would be prepared to rent your office block • C3 = $466,000 = ($16,000 + $450,000): 3rd year
for 3 years at a fixed annual rent of $16,000. cash flow
Mr. A forecast that, after the third year’s rent, the • Including rental income and forecast sale price
building could be sold for $450,000.
The opportunity cost of capital is 7%. Should Mr. A 16,000 16,000 466,000
go ahead? PV = + +
1 + 0.07 (1 + 0.07)2 (1 + .07)3

= 409,323

Valuing Long-lived projects

• The initial cost:

50,000 + 300,000 = 350,000 $
• So, your net gain is:
Net gain = $409,323 – $350,000
Cash flows and their present values = $59,323
for office block project.
 The NPV rule works for NPV OF LONG-LIVED
projects of any duration: PROJECTS - Example
Consider the following cash flows for a
Simply project and consider an opportunity cost
discount the Then of capital of 5%. Is the project a good
cash flows at subtract the investment?
the cost of the
appropriate initial -3,000 5,500 8,000 10,000
opportunity investment.
cost of capital
-15,000

The critical problems in any NPV

problem are to determine: NPV OF LONG-LIVED
PROJECTS
• The amount and timing of the cash
flows. - solution
• The appropriate discount rate.
• Notice: There could be a different
opportunity cost of capital for each
period’s cash flow. In that case, we
could discount C1 by r1, C2 would be
discounted by r2, and so on.
 Valuing Long-lived projects -
homework
A proposed nuclear power plant will cost $2.2 billion
to build and then will produce cash flows of $300
million a year for 15 years. After that period (in year Internal Rate of
15), it must be decommissioned and liquidated at a
cost of $900 million. With the discount rate is 6 return
percent, should this project go head?

Rate of return - Definition

• A rate of return used in capital

OTHER budgeting to measure and
INVESTMENT compare the profitability of
investment.
CRITERIA
 RATE OF RETURN Internal rate of return
• The project’s internal rate of
Rate of Profit
= return is known as the discount
return Investment
C1 – investment cash flow (DCF) rate of return.
=
Investment • The IRR is the discount rate at
C1 - C0
= which the cash flow would have
C0
zero NPV.

INTERNAL RATE OF RETURN Exercise

- Definition
• Internal rate of return (IRR)
is the rate of return that would
make the present value of future
cash flows plus the final market
value of an investment or
business opportunity equal the
current market price of the
investment or opportunity
Assume Company XYZ must decide whether to
purchase a piece of factory equipment for $300,000.
The equipment would only last three years, but it is
expected to generate $150,000 of additional annual
profit during those years. Company XYZ also thinks it
can sell the equipment for scrap afterward for about
$10,000. Using IRR, Company XYZ can determine
whether the equipment purchase is a better use of its
cash than its other investment options, which should
return about 10%.
 Internal rate of return
• If the opportunity cost of capital is
less than a project’s IRR, the project
has positive NPV and vice versa.
We compare the project IRR with
the opportunity cost of capital, we
are effectively asking whether the
project has a positive NPV.
• The higher NPV of project is, the
more attractive the project is.
Decision rules
• The NPV rule. Invest in any project
that has a positive NPV when its
cash flows are discounted at the
opportunity cost of capital.
• The rate of return rule. Invest in
any project offering a rate of return
that is higher than the opportunity
cost of capital.

NPV & Irr

• The rate of return rule will give the same
answer as the NPV rule as long as the NPV of
a project declines smoothly as the discount Calculating the Rate of
rate increases. return for Long-lived
• Both IRR and NPV are concerned with projects
identifying those projects that make
shareholders better off and both recognize
that companies always have a choice of
whether investing a project.
 2.1.2 Calculating the rate of return for
The linear interpolation method long-lived project – example 2
Step 1: Pick an interest rate (r1). Calculate NPV1
after r1
A 3-year project with an investment of VND
150 million is planned to generate VND 40
Step 2: If NPV1 < 0, pick r2 so NPV2 > 0, and vice million in the 1st period, VND 60 million in 2nd
versa period, and VND 90 million in 3rd period.
Calculate the project’s IRR.
Step 3:
NPV1
IRR = r1 + (r2 - r1 ) × 40 60 90
NPV1 + NPV2 NPV = + + - 150 = 0
1 + IRR 1 + IRR 2 1 + IRR 3

Notice: For the best accuracy, try to keep the

difference between r1 and r2 less than 5%

2.1.2 Calculating the rate of return for

long-lived project – example 1 2.1.3. A word of caution:
You plan to invest $ 350,000 in construction of an
office block. If you rent out the office for 3 years,
the cash flow are as follows: Internal Opportunity
Year 1 2 3 4 rate of cost of
Cash
flows
(350,000) 16,000 16,000 466,000 return capital
What is the IRR for the revised office project?
 A word of Caution Payback PERIOD

• The project IRR measures the Payback period

profitability of the project. is the length of
Depending only on the project’s own
cash flows. time before you
• The opportunity cost of capital is the recover your
standard for deciding whether to initial
accept the project.
investment

Payback period
• An important determinant of
whether to undertake the
Payback position or project, as longer
payback periods are typically
not desirable for investment
positions.
 Payback – Formula Payback rule
A project should be accepted if its
payback period less than a specified
Initial investment cutoff period.
Payback period =
Annual cash inflows
E.g: If the cutoff period is 6 years
that project makes the grade
If the cutoff period is 4 years it
doesn’t

Payback
Payback period - example
• As a rough rule of thumb the payback rule
Project cost: $100.000 maybe adequate, but it is easy to see that it
can lead to nonsensical decisions.
Expect of return: $20.000 per years
Project A Project B
The payback period: 100000 : 20000 = 5 years
Payback period 2 years 2 years
NPV >0 <0
All other thing being equal, the
better investment is the one with The project A is clearly superior, but
the shorter payback period the payback rule ranks both equally.
Payback period - Advantages Payback period - METHODS

• Simple to apply We only use this method when:

• The capital investment is small.
• The merits of the project are so
• Still applicable due to offsetting
obvious that more formal analysis
benefits is unnecessary.

Cash flow, Dollars

Payback period - Disadvantages
Payback
• It ignores any benefits that C0 C1 C2 C3 period,
NPV at
10%
occur after the payback period Years

and therefore, does not measure

profitability. A -2,000 +1,000 +1,000 +1,000 2 $7,249

• It ignores the time value of B -2,000 +1,000 +1,000 0 2 -$264

money.
C -2,000 +2,000 0 2 -$347

BOOK RATE
OF RETURN
(BRR)
Book rate of return -
Definition
• Book rate of return (accounting rate
of return-ARR) is the expected profit
based on an investment made. BRR
divides the average profit by the
initial investment in order to get the
ratio or return that can be expected.
2.1.5 Book rate of return
✓ If book rate of return is x% the project is expected to
earn X dong out of 100 dong invested
✓ If the book rate of return is equal to or greater than
the required rate of return, the project is acceptable.
If it is less than desired rate, it should be rejected.
✓ When comparing investments, the higher the BRR,
the more attractive the investment
Book income
Book rate of return =
Book assets
Average accounting profit
=
Initial investment
• A project is chosen when
- The BRR is equal to or greater than
required BRR.
- It has the highest BRR among mutual
exclusives projects.
 Book rate of return -
Disadvantages
• BRR depends on which items the
accountant chooses to treat as PROJECT
capital investments and how
rapidly they are depreciated. INTERACTIONS
• BRR does not consider time value
of money

Book rate of return -

Disadvantages
• BRR does not consider cash flows
• BRR can give misleading impression of Mutual Exclusive
the attractiveness of a project
• BRR can easily give a misleading Projects
impression of the attractiveness of a
project.
 Mutual Exclusive Projects -
Definition
• A set of projects from which at
most one will be accepted.
• Cash flows of one project can
be adversely affected by the
acceptance of the other
projects.
Mutual Exclusive Projects -
Example
• You could build an apartment block
on a vacant site rather than build
an office block, a 5-storey office
block or a 50-storey one, heat it
with oil or with natural gas, build it
today, or wait a year to start
construction.
Mutual Exclusive Projects -
Decision rules:
• Calculate the NPV of each project and,
from those options that have a positive
NPV, choose the one with highest NPV.
• However, sometimes the choice can
depend on different factors like initial
investment, time period required for
completion, strategic importance of the
project, etc.
The three common decisions
in choosing mutual exclusive
projects:
• The investment timing decision.
• The choice between long- and
short-lived equipment.
• The replacement decision.
 LONG-TERM VERSUS
SHORT-TERM EQUIPMENT

Long - versus Short - lived Year 0 1 2 3

equipment Machine
15 4 4 4
D
Machine
10 6 6 -
E

LONG-TERM VERSUS LONG-TERM VERSUS

SHORT-TERM EQUIPMENT
SHORT-TERM EQUIPMENT
• Suppose the firm is forced to choose between
two machines, D and E. The two machines are
designed differently but have identical capacity
Year 0 1 2 3 PV at 6%
and do exactly the same job.
• Machine D costs $15,000 and will last 3 Machine D 15 4 4 4 25.69
years. It costs $4,000 per year to run.
• Machine E is an economy model, costing Machine E 10 6 6 21.00
only $10,000, but its will last only 2
years and costs $6,000 per year to run.
 LONG-TERM VERSUS Equivalent annual
SHORT-TERM EQUIPMENT cost - FORMULA
Calculate present value of costs
Compare the EAC =
projects on a equivalent annuity factor
like-for-like annual cost
basis of each
project 1 1
Annuity factor = -
r r. 1 + r t

LONG-TERM VERSUS
Equivalent annual cost
SHORT-TERM EQUIPMENT
• The equivalent annual cost is the
annual (annuity or payment) project Equivalent
Machine Machine
cost that equates the present value cost annual cost
A B
of the project (outlay and annual costs) (EAC)
at the opportunity rate of return. PV = $
PV= $ 21.00 Calculate the
• The equivalent annual cost is the level 25.69
annual charge or cost necessary to EAC of each
Life is 2
recover the present value of investment Life is 3 machine
years
years
outlays and operating costs.
 LONG-TERM VERSUS SHORT-TERM
EQUIPMENT - The Equivalent Annual Cost Decision Rule
Method
❖ When comparing mutually exclusive
• Machine D: projects that have unequal project lives, one
PV at must analyze the costs of the projects, the
Year 0 1 2 3
6%
outlays and the annual costs of the projects.
Machine D 15 4 4 4 25.69
Equivalent ❖ Calculate the equivalent annual cost of
3-year - 9.61 9.61 9.61 25.69 both machines ⟹ Accept the project with the
annuity lowest equivalent annual cost.

LONG-TERM VERSUS SHORT-TERM

EQUIPMENT - The Equivalent Annual Cost
Method

• Machine E:
Costs, Thousands of Dollars Replacing an Old Machine
Year 0 1 2 PV at 6%
Machine E 10 6 6 21.00
Equivalent 2 -
- 11.45 11.45 21.00
year annuity
 Replacing an Old Machine - Replacing an Old Machine -
Reasons Example
• You are operating an old machine that will last 2
• When the machine presents an more years before it gives up the ghost. It costs
$12,000 per year to operate
uncceptable safety risk, replace it!
• You can replace it now with a new machine, which
• It is no longer cost effective to maintain costs $25,000 but is much more efficient ($8,000
per year in operating costs) and will last for 5 years
• Customers’ demand is changed and the
• The opportunity cost of capital is 6 percent (r = 6%)
machine cannot meet it
➢ Should you replace now or wait a year?
• It cannot meet production requirements.

Replacing an Old Machine -

Replacing an Old Machine –
Solution
Right Decision?
❖ We can calculate:
• The old equipment can still have a
➢The PV of the new machine
good performance
➢Its equivalent annual cost
• Sometimes new equipment does
not always result in any increase in
gross revenue ❖ We compare old machine’s costs
and new machine’s costs a year to
run
 Capital rationing - Definition
Capital rationing is the strategy of
3.3 Replacing an picking up the most profitable
projects to invest the available funds
old machine –
Solution

Capital rationing - Definition

• Placing restrictions on the amount of

CAPITAL new investments

undertaken by a company.
or projects

RATIONING • This is accomplished by imposing a

higher cost of capital for investment
consideration or by setting a ceiling
on the specific sections of the budget
 Soft rationing
Types of capital rationing
• Soft rationing is when the firm itself
limits the amount of capital that is
going to be used for investment
decisions in a given time period
Soft Hard
rationing rationing

Hard rationing
• Hard capital rationing or “external” rationing
occurs when the company faces problems in
raising funds in the external equity markets.
• This can lead to the shortage of capital to
Soft rationing finance the new projects in the company
 How to choose projects when
shortage of capital?
• Suppose that the opportunity cost of capital is 10%,
that the company has total resources of $20 million,
and that it is presented with the following project
proposals (Cash flows, Millions of Dollars)

Project C0 C1 C2
PV at
10%
NPV EXERCISES
L -3 2.2 2.42 $4 $1
M -5 2.2 4.84 $6 $1
N -7 6.6 4.84 $10 $3
O -6 3.3 6.05 $8 $2
P -4 1.1 4.84 $5 $1

How to choose projects when EXERCISES

shortage of capital? Project A and project B are mutual exclusive. Both
• All 5 projects have a positive NPV, However, the require an VND100 mil. investment and will last 3
capital is limited with $20 mil. years. The cash flows for project A in 3 years are
• ⟶ The firm will accept the projects which give the VND10 million, VND60 mil., and VND80 mil.,
highest NPV per dollar of investment respectively. The cash flows for project B are VND 70
mil., VND 50 mil., and VND 20 mil.. Suppose the
Profitability average cost of capital is 10%. Which project should
Project PV Investment NPV
index be accepted?
L $4 $3 1 1/3 = 0.33
M $6 $5 1 1/5 = 0.20
N $10 $7 3 3/7 = 0.43
O $8 $6 2 2/6 = 0.33
P $5 $4 1 1/4 = 0.25
The following cash flows related to 2 projects:
Year 0 1 2 3 4 5 6
Project A -60 20 20 20 20 20 20
Project B -72 45 22 20 13 13 13
(In thousands dollar)

• Calculate the NPVs for each project,

assuming 10% cost of capital.
• Assuming that the two projects are
independent, would you accept them if
the cost of capital is 15%?
• What is the IRR of each project?