FINA1027 Lecture 5 Investment Appraisal II

Lecture 5:
Investment Appraisal: Application & Risk
Panagiotis Panagiotou
FINA1027 Finance
Department of Accounting, Finance, and Economics
Greenwich Business School
October 25, 2022

p.panagiotou@greewich.ac.uk
Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 1 / 55

Learning Objectives
By the end of this session, you will be able to:
Understand the techniques to be employed in order to arrive at the best

investment decision if capital is rationed.
Understand the rules to follow when investment appraisal is done in an

environment of taxation and inflation.
The distinction between risk and uncertainty.
Application of sensitivity analysis to investment projects.

Capital Rationing
Shareholder wealth is maximised if a company undertakes all possible

positive NPV projects.
Capital rationing occurs when a firm has a fixed amount of funds to invest,
and these funds are not enough to undertake all projects with a positive NPV.
If the company has more profitable projects than it has funds for, it must
allocate the funds to achieve the maximum shareholder value subject to the
funding constraints.
Two types of capital rationing:

- Hard (external) capital rationing
- Soft (internal) capital rationing

Hard Capital Rationing
May be imposed externally - external factors preventing a company from

raising additional funds (i.e., by circumstances beyond its control):
- A covenant attached to an existing loan may not allow additional funds to

be raised.
- Investors consider the company to be too risky.
- A downgrade in its credit rating.
- General situation of the economy or industry-wide factors limiting funds.

Soft Capital Rationing
Soft capital rationing may be imposed internally by management (i.e., the

company has freely chosen to impose some restrictions on its capital
expenditure):
- Managers may decide against raising additional equity finance because

they wish to avoid dilution (i.e., reduction) of control or earnings per
share.
- Managers may decide against raising additional debt finance in order to

avoid interest payment obligations / effect on gearing / financial risk.
- Limited management skills available for a few projects.

Capital Rationing
Single-period capital rationing: shortage of funds for the current period only.
Multi-period capital rationing: shortage of funds in more than one period.
If the company has more profitable projects than it has funds for, it must
allocate the funds to achieve the maximum shareholder value subject to the
funding constraints.
The aim is to maximize the NPV earned per £1 invested in projects.

Divisible Projects
A distinction must be made between [I] divisible and [II] non-divisible projects.
If a project is divisible (i.e. can be done in part):
- any fraction of the project may be undertaken

- the returns from the project are expected to be generated in exact
proportion to the amount of investment undertaken.
In this case:
- Calculate the Profitability Index (see below);

- Rank the projects according to their Profitability Index, from the
highest value to the lowest value;
- Allocate funds according to the projects’ ranking until they are used
up.

Profitability Index
The Profitability Index (PI) is defined as the PV of a project’s future CFs

divided by the initial investment.
PV of Future Cash Flows NPV

PI = = 1 +
Initial Investment Initial Investment
The PI indicates the value you are receiving in exchange for each £1
invested.
The investment decision rule for the PI is as follows:

Invest if PI > 1
Do not invest if PI < 1
This is consistent with the NPV approach.

Example #1: PI calculation
Project Initial Investment Cash Inflows NPV Profitability

(£’000) (£’000) (£’000) Index
115
A (100) 115 15 100 = 1.15
179
B (150) 179 29 150 = 1.19
171
C (140) 171 31 140 = 1.22
216
D (180) 216 36 180 = 1.20
Alternatively:
PIA = 1 + (15/110) = 1 + 0.15 = 1.15

PIB = 1 + (29/150) = 1 + 0.19 = 1.19
PIC = 1 + (31/140) = 1 + 0.22 = 1.22
PID = 1 + (36/216) = 1 + .020 = 1.20

Example #1: PI calculation (cont.)
Project Initial Investment Cash Inflows NPV Profitability Ranking

(£’000) (£’000) (£’000) Index
115
A (100) 115 15 100 = 1.15 4th
179
B (150) 179 29 150 = 1.19 3rd
171
C (140) 171 31 140 = 1.22 1st
216
D (180) 216 36 180 = 1.20 2nd
Alternatively:
PIA = 1 + (15/110) = 1 + 0.15 = 1.15

PIB = 1 + (29/150) = 1 + 0.19 = 1.19
PIC = 1 + (31/140) = 1 + 0.22 = 1.22
PID = 1 + (36/216) = 1 + .020 = 1.20

Example #2: optimum investment schedule
Project A B C D
Initial Investment (£) 500 650 800 850
Net Present Value (£) 650 715 800 765
Ranking by NVP 4 3 1 2
But our available capital is £1,650.
PIA = 1 + (650 / 500) = 1 + 1.3 = 2.3
PIB = 1 + (715 / 650) = 1 + 1.1 = 2.1
PIC = 1 + (800 / 800) = 1 + 1.0 = 2.0
PID = 1 + (765 / 850) = 1 + 0.9 = 1.9

Example #2: optimum investment schedule (cont.)
Project A B C D
Initial Investment (£) 500 650 800 850
Net Present Value (£) 650 715 800 765
Profitability Index (PI) 2.3 2.1 2.0 1.9
Ranking by NVP 4 3 1 2
Ranking by PI 1 2 3 4
The company should therefore take on projects until the available capital
(£1,650) is exhausted (we assume projects are divisible):
Investment NPV (£) Cumulative Investment (£)

£500 invested in project A 650 500
£650 invested in project B 715 1,150
£500 invested in project C 500 1,650
Total NPV for £1,650 invested 1,865

Non - Divisible Projects
If a project is non-divisible (i.e. cannot be done in part):

- it must be done in its entirety or not at all.
In this case:
- The optimal combination can be found by trial and error.
- Calculate the NPV of different combinations.
- Select the combination with the highest NPV that does not exceed
the available capital.

Example #3: non-divisible projects
A company has £100,000 available for investment and has identified the
following 5 investments in which to invest.
Assume that the projects are non-divisible. Determine which projects should
be chosen.
Project Initial Investment NPV

(£’000) (£’000)
C 40 20
D 100 35
E 50 24
F 60 18
G 50 -10

Example #3: non-divisible projects
Project or Initial Investment NPV

Combination (£’000) (£’000)
C 40 20
D 100 35
E 50 24
F 60 18
C+E 40 + 50 < 100 20 + 24 = 48
C+F 40 + 60 < 100 20 + 18 = 38
The combination that maximizes the NPV for the given capital is to invest in
projects C and E.

Cash Flows Estimation
General Rule: We should take into account all and only the monetary consequences
that the implementation of the project has on the wealth of the shareholders.
Do not consider cash flows that would occur independently of the

implementation of the project.
Consider all direct and indirect cash flows generated with the implementation of
the projects.
in other words, consider only "all future relevant and incremental cash flows".
The incremental approach consists in comparing the firm’s future cash-flows with and
without the project implementation.
The cash flows that are relevant to an investment appraisal calculation are
those which will arise or change by undertaking the investment project.

Cash Flows Estimation
Which cash flows are relevant in our NPV calculation? How should they be
treated?
1 Sunk costs
2 Taxes
3 Capital allowances
4 Inflation
5 Investment in working capital
6 Interest payments
The cash flows that are relevant to an investment appraisal calculation are
those which will arise or change by undertaking the investment project.
[1] Treatment of Sunk Costs
Sunk costs are any costs incurred or committed to before the current
investment decision is made.
R&D expenditures
costs related to feasibility studies
past salaries related to the project
Sunk costs should not be taken under consideration as these costs do

not result from the investment being considered and the current decision of
whether or not to undertake the project cannot change the sunk costs.
It is only the costs that will be incurred in the future that are relevant to the
current investment appraisal.

[2] Treatment of Taxation
While we are ultimately interested in cash flow - not profit - we need the
income calculation to determine taxes.
Operating cash inflows increase taxable income, taxed at the

corporation tax rate.
Operating cash outflows decrease taxable income, making it tax

deductible and attracting tax relief at the corporation tax rate.
Capital expenditures attract tax-allowable depreciation (pls refer to the

slides on writing capital allowances.)
Typically, we assume that tax is paid one year after the related operating
cash flow is earned (unless told otherwise).
Thus, taxes should be taken into consideration, as should the time at

which they are paid.
[3] Treatment of Capital Allowances
In the UK, the government allows companies to claim capital allowances

(CAs) when they buy a tangible asset (e.g., PPE).
Part or all of the value of the asset can be deducted from annual profits
before the company pays tax (thus, reduces the amount of tax that
companies are required to pay).
In essence, CAs are a form of tax relief with the objective of helping
companies make capital expenditures.
Thus, capital allowances should be taken under consideration while

we calculate the taxable income of the company, but should not be
taken under consideration in investment appraisal as they
represent a non-cash expense.

[3] Treatment of Capital Allowances (cont.)
CAs are calculated based on the written down value of the asset, either
on [1] a reducing balance or [2] a straight line basis.
The total CA given over the life of an asset equates to the cost less any
scrap proceeds.
A balancing allowance arises in the year of sale or scrap.
Thus, CAs are set off against the CFs arising from projects.
Most capital allowance payments are treated as occurring in the year

after the one to which they relate (time-lag).

Example #4: calculation of capital allowances
Scenario: A company is considering whether or not to purchase a machine

costing £40,000. The machine would have a life of 4 years, after which it
would have a scrap value of £5,000.
The machine would create cost savings of £14,000 per year for the life of the
machine.
The after-tax cost of capital is 8%. Assume a corporate tax rate of 30%.
Should the machine be purchased?

Example #4 (answer): general approach
1 Determine the cash flow from operations (pre-tax cash flows).
2 Deduct the capital allowances to give the taxable income.
In this scenario, the machine would have a life of 4 years. Thus, we

implicitly assume running depreciation on a straight line basis.
Therefore, we can claim writing down allowance (WDA) at a rate of 25%
per year.
3 Calculate the tax (assuming a corporation tax rate of 30%) on the

taxable income.
4 Include the after tax cash flows in your calculation of the NPV of the
project.

Example #4 (answer): working 1 - WCA
Year Opening b/c Capital Allowance Closing b/c

1 40,000 40,000 × 25% = 10,000 30,000
2 30,000 30,000 × 25% = 7,500 22,500
3 22,500 22,500 × 25% = 5,625 16,875
4 16,875 16,875 × 25% = 4,219 12,656
Total = 27,344
Initial value = 40,000

Scrap value = (5,000)
Amount depreciated over the useful life = 35,000
CA total to the end of year 4 = (27,344)
Amount of Year 4 balancing allowance = 7,656
For tax purposes year 4 Capital allowance = 4,219 +7,656 = 11,875

Example #4 (answer): working 2 - Tax Payable
Year 1 2 3 4 5
CFs from operations 14,000 14,000 14,000 14,000
Capital Allowance (10,000) (7,500) (5,625) (11,875)
Taxable Profit 4,000 6,500 8,375 2,125
Tax Payable 0 1,200 1,950 2,512 638
Profit After-Tax 4,000 5,300 6,425 (387) (638)
Tax Payable at Year 2 = 4,000 × 30% = 1,200

Tax Payable at Year 5 = 2,125 × 30% = 638

Example #4 (answer): working 3 - NPV Calculation
Year 0 1 2 3 4 5
Initial Investment (40,000)
Scrap Value 5,000
Cost Savings 14,000 14,000 14,000 14,000
Tax Payable 0 (1,200) (1,950) (2,512) (638)
After-tax CF (40,000) 14,000 12,800 12,050 16,488 (638)
1 1 1 1 1
Discount Factor (1+8%)1
= (1+8%)2
= (1+8%)3
= (1+8%)4
= (1+8%)5
=
1 0.926 0.857 0.794 0.735 0.681
Discounted CF (40,000) 12,964 10,970 9,568 12,119 (434)
NPV = £5,187 > 0, thus the machine should be purchased.

Example #4 (answer): working 3 - NPV Calculation
NOTE: The same working as above, but from a different starting point,
yields the same result.
Year 0 1 2 3 4 5
Profit After-Tax 4,000 5,300 6,425 (387) (638)
Add back CAs 10,000 7,500 5,625 11,875
Initial Investment (40,000)
Scrap Value 5,000
After-tax CF (40,000) 14,000 12,800 12,050 16,488 (638)
1 1 1 1 1
Discount Factor (1+8%)1
= (1+8%)2
= (1+8%)3
= (1+8%)4
= (1+8%)5
=
1 0.926 0.857 0.794 0.735 0.681
Discounted CF (40,000) 12,964 10,970 9,568 12,119 (434)
NPV = £5,187 > 0, thus the machine should be purchased.

[4] Treatment of Inflation
Inflation measures how much more expensive a set of goods and services
has become over a certain period, usually a year.
It means, you can buy less for £1 today than you could yesterday. In other
words, inflation reduces the value of the currency over time.
Inflation can have a serious effect on capital investment decisions by both

reducing the value of future cash flows and/or increasing the uncertainty
about these cash flows.
Investment appraisal can take account of inflation in two ways:
1 By discounting nominal (money) cash flow with a nominal cost of capital;

2 By discounting real cash flow with real cost of capital.

Reminder: Real and Nominal Interest Rates I
Consider the following three rates:
Inflation rate: the (usually annual) rate at which the level of prices in the
economy grows. Denote it by π.
Nominal interest rate: the rate at which the balance of a deposit grows
in cash terms. Denote it by r.
Real interest rate: the rate at which the balance of a deposit grows in
purchasing power terms. Denote it by i.
Comments:
If you’re given nominal cashflows, you should discount them at the

nominal rate.
If you’re given real cashflows, you should discount them at the real rate.

Reminder: Real and Nominal Interest Rates II
The real cost of capital (i.e., the real discount rate) is found by deflating the
nominal (or money) cost of capital.
Real Interest Rate: we define the real interest rate to be;
(1 + r )
(1 + i) =
(1 + π)
Approximate real interest rate: we have;
(1 + r ) = (1 + i) × (1 + π) ⇒ (1 + r ) = 1 + i + π + iπ
When rates are low, iπ will be very small. Thus we ignore it and obtain;
(1 + r ) ≈ 1 + i + π ⇒ i ≈ r −π
This equation is known as the Fisher Equation.

Example #5: calculation of real discount rate
Money (or nominal) cost of capital (r) = 16.6%;
Annual inflation rate (π) = 6%;
Real cost of capital (i) ⇒
(1 + r ) (1 + 16.6%)
(1 + i) = ⇒ (1 + i) = ⇒ i = 10%
(1 + π) (1 + 6%)

Reminder: Real and Nominal Interest Rates III
Comments:
If the nominal interest rate (r) is below the inflation rate (π), then a
deposit is losing money in purchasing power terms. On the flipside, a
debt will shrink in real terms if r < π.
In times of inflation, the fund providers will require a higher return

to compensate for inflation.
Inflation rates can be substantial, implying that the difference between

real and nominal rates can be large.
- Assume nominal rates are 12% and inflation is running at 8%.
- The approximate real rate is 4% (the precise real rate is 3.7%).
Note: the larger are rates, the bigger the approximation error (iπ) in the
approximate real rate calculation above.

[4] Treatment of Inflation (cont.)
CFs that have not been increased for expected inflation; they are known
as real (or in today’s prices) cash flows.
CFs that have been increased (with specific or general inflation rates) to
take account of expected inflation are known as nominal (or money)
cash flows.
Nominal cash flows deflated by general rate of inflation are real cash
flows.
You can assume that cash flows you are given in the exam are nominal
cash flows unless told otherwise.
NPV found by discounting real cash flows with real cost of capital is
same as NPV found by discounting nominal cash flows with nominal
cost of capital.
Example #6: NPV with real vs nominal CFs
Smart e-Transfer is a money transfer service allowing private individuals and

businesses to send money abroad without hidden charges. The company is
considering developing an update to its digital platform. The project has the following
real cash flows before allowing for inflation.
Year Cash Flow (£)

0 (750)
1 330
2 242
3 532
The company’s nominal discount rate is 15.5%. The general rate of inflation is
expected to remain constant at 5%.
a Evaluate the project in terms of real cash flows and real discount rates.
b Evaluate the project in terms of nominal cash flows and nominal discount rates.

Example #6a (answer): NPV with real CFs
We need to derive the real cost of capital in order to discount the real cash flows with
the real cost of capital.
We can estimate the real cost of capital using the Fisher equation:
(1+r ) (1+15.5%)
(1 + i) = (1+π)
⇒ i= (1+5%)
− 1 = 10%
Year Real CF (£) DF (i = 10%) Discounted CF

0 (750) 1 (750)
1 330 0.909 300
2 242 0.826 200
3 532 0.751 400
NPV = 150

Example #6b (answer): NPV with nominal CFs
We need to discount nominal cash flows with the nominal discount rate. Nominal cash
flow can be obtained by inflating estimated real cash flows to take account of inflation.
To convert real cash flows into nominal flows they will need to be increased by 5%
each year from year 0, to allow for inflation. The nominal discount rate (as per the
scenario) is 15.5%.
Year Real CF (£) Nominal Cash Flow (£) DF (r = 15.5%) Discounted CF

0 (750) (750) 1 (750)
1 330 330 ×(1 + 5%) = 346.5 0.866 300
2 242 242 ×(1 + 5%)2 = 266.8 0.750 200
3
3 532 532 ×(1 + 5%) = 615.9 0.649 400
NPV = 150
Note that either approach yields identical conclusions (allowing for rounding).
NPV value will be the same whichever method is used.

[5] Treatment of Working Capital
Investment in a new project often requires an additional investment in working

capital, i.e. the difference between short-term assets and liabilities.
To calculate the working capital cash flows you should:

1st: calculate the absolute amounts of working capital needed in each period
2nd: work out the incremental cash flows required each year.
initial investment in working capital is a cost at the start of the project
if the investment is increased during the project, the increase is a

relevant cash outflow
at the end of the project all the working capital is released and treated as
a cash inflow.

[6] Treatment of Interest Payments
Interest payments on debt are an allowable deduction in calculating

taxable profit.
However, interest payment on debt must not be included in a

domestic investment appraisal.
Cost of capital used as the discount rate includes the effect of interest
payment.
Tax shield on debt is accounted for by using an after-tax discount rate.

Why assessing risk in investment appraisal
All decisions are based on forecasts (i.e., about future cash inflows and
outflows, interest rates, project life, inflation rates, etc.).
All forecasts are based on assumptions about the future behaviour of the
variables.
Because of the ever-changing business environment, the behaviour

of those variables cannot be predicted with precision.
How do you deal with risk and uncertainty?

How can risk and uncertainty be incorporated into investment appraisal?

Risk and Uncertainty
Risk: refers to a set of possible future outcomes (i.e., different future

states of the world) which are known and whose likelihood (probabilities)
of occurrence can be estimated (or predicted).
Example: Based on past experience of digging for oil in a particular area, an oil
company may estimate that they have a 60% chance of finding oil and a 40%
chance of not finding oil.
Uncertainty: refers to a set of possible future outcomes whose

likelihoods cannot be estimated (or predicted).
Example: An oil company has identified the location of a potential oil reservoir.
The company knows that it is possible for them to either find or not find oil but it
does not know the exact probabilities of each of these outcomes.

Risk and Uncertainty (cont.)
Risk: refers to a set of possible future outcomes which are known and
whose likelihood of occurrence can be estimated.
- Risk increases with the variability of outcomes.

- Risk can be measured and quantified (since probabilities can be
estimated).
- A risk may be taken or not. If taken, protection (to some degree) can be
purchased or take measures.
Uncertainty: refers to a set of possible future outcomes whose likelihood

of occurrence cannot be estimated
- We do not know the probability of each possible future outcome.

- Unquantifiable.
- Uncertainty is a circumstance that must be faced by all.
- Uncertainty does not allow to take steps to protect since no one can
exactly predict future events.

Sensitivity Analysis
Sensitivity Analysis (What-if analysis) is used to address project
uncertainty.
Sensitivity analysis examines how sensitive a particular NPV calculation

is to changes in underlying assumptions.
Example: What if demand falls by 10% compared to our original

forecast? Would the project still be viable? [selling price, market share,
size of the market, costs, inflation rates etc.]
There are two methods:

- Changing variables by a set amount then recalculating NPV.
- Finding a change in a variable which gives a zero NPV.
Note: Only one variable is changed at a time, all other variables remain
fixed.
Sensitivity Analysis (cont.)
The maximum possible change is often expressed as a percentage:
NPV
Sensitivity Margin (%) = × 100
PV of Variable under consideration
This would be calculated for each input individually.
The lower the sensitivity margin, the more sensitive the decision is
to the particular variable being examined.
Why? Because small changes in the estimate could change the project
decision from accept to reject.

Example #7: calculation of sensitivity margin
Based on the information below:
Initial Investment £7m

Selling Price £9.20 per unit
Sales Volume 800,000 units
Variable Cost £6.00 per unit
Project Life 4 years
Cost of Capital 12%
Assess the sensitivity of the project to changes in initial investment, selling

price, and sales volume.

Example #7: answer
Year 0 1 2 3 4
Initial Investment (7,000,000)
Sales Revenue 7,360,000 7,360,000 7,360,000 7,360,000
Total Variable Costs 4,800,000 4,800,000 4,800,000 4,800,000
Net Cash Flow (7,000,000) 2,560,000 2,560,000 2,560,000 2,560,000
Discount Factor (r=12%) 1 0.893 0.797 0.712 0.636
Discounted CF (7,000,000) 2,285,714 2,040,816 1,822,157 1,626,926
NPV = £775,614

Example #7: answer (cont.)
Initial Investment
If the initial investment increases by £775,614, the PV becomes zero:
NPV 775,614
Sensitivity Margin = PV of Initial Investment
× 100 = 7,000,000
× 100 = 11.1%
Selling Price
The relative decrease in selling price per unit that makes the NPV zero is the
ratio of the NPV to the PV of sales revenue:
NPV 775,614
Sensitivity Margin = PV of Sales Revenue
× 100 = 22,354,891
× 100 = 3.5%
Sales Volume
The relative decrease in sales volume that makes the NPV zero is the ratio of the
NPV to the PV of contribution (i.e., P - VC, excl. the cost of initial inv.):
NPV 775,614
Sensitivity Margin = PV of Contribution
× 100 = 7,775,614
× 100 = 10%

Sensitivity Analysis (cont.)
Advantages:
Simple to understand and implement.
Allow management to make subjective judgements.
Identifies critical variables.
Disadvantages:
Considers only one variable each time.
Assumes variables change independently of each other.
Does not access the likelihood of a variable changing.
Extension: Simulation analysis

Risk in Project Investment
Risk: refers to a set of possible future outcomes and the probability of

each future outcome can be estimated.
A probability distribution of expected cash flows allows us to calculate

the mean NPV, i.e. the expected NPV (ENPV).
And measure risk as:

- The probability of worse case;
- The probability of failing to achieve a positive NPV;
- Calculating the standard deviation of the possible outcomes.

Risk in Project Investment (cont.)
The expected value is the weighted average of all possible future

outcomes, with the weights being the respective probabilities estimated.
N
X
ENPV = pi NPVi
i=1
This approach can give more useful information than single-point NPV
estimates, but the ENPV is an average value that is unlikely to occur in
reality.

Example #8: ENPV
What is the ENPV of the following project?
Scenario (i) Probability (p) NPV

Best Case 0.2 £30,000
Most Likely 0.7 £20,000
Worst Case 0.1 £10,000
In this scenario, we have 3 possible future states of the world, thus N = 3.

N
X 3
X
ENPV = pi NPVi = pi NPVi
i=1 i=1
= (p1 × NPV1 ) + (p2 × NPV2 ) + (p3 × NPV3 )
= (0.2 × £30, 000) + (0.7 × £20, 000) + (0.1 × £10, 000)
= £21, 000

Risk-adjusted discount rates I
The discount rate we have assumed so far is the rate that reflects either:
the cost of borrowing funds;
the required rate of return of the business (i.e., the return required by the
shareholders);
or a mix of both.
If an individual investment or project is perceived to be more risky than

existing investments, the increased risk could be used as a reason to
adjust (increase) the discount rate.
The addition to the usual discount rate is called the risk premium.
The greater the risk attached to future returns, the greater the risk premium
required.

Risk-adjusted discount rates II
Thus we can view an interest rate r as being composed of a real risk-free interest rate
plus a set of four premiums that are required returns or compensation for bearing
distinct types of risk:
r = real risk-free interest rate + inflation premium

+ default risk premium + liquidity premium
+ maturity premium
real risk-free interest rate (rf ): is the single-period interest rate for a completely
risk-free security if no inflation were expected.
inflation premium (π): compensates investors for expected inflation and

reflects the average inflation rate expected over the maturity of the debt.
default risk premium: compensates investors for the possibility that the
borrower will fail to make a promised payment at the contracted time and in the
contracted amount.

Risk-adjusted discount rates II
liquidity risk: compensates investors for the risk of loss relative to an

investment’s fair value if the investment needs to be converted to cash quickly.
maturity premium: compensates investors for the increased sensitivity of the

market value of debt to a change in market interest rates as maturity is
extended, in general (holding all else equal).

Summary and Conclusions
Divisible projects can be ranked using the PI. Combinations of indivisible

projects must be considered on a trial and error basis.
Capital budgeting must be placed on an incremental basis.
Inflation must be handled consistently. One approach is to express both cash

flows and the discount rate in nominal terms. The other approach is to express
both cash flows and the discount rate in real terms. Because both approaches
yield the same NPV calculation, the simpler method should be used. The
simpler method will generally depend on the type of capital budgeting problem.
Risk refers to situations where the probabilities of future events are known.
Uncertainty refers to circumstances where the probabilities of future events are
not known.
Sensitivity analysis shows NPV under varying assumptions, giving managers a

better feel for the project’s risks.

Before you go
Required reading: Corporate Finance (Head and Watson), Chapter 7.
Tutorial and support session questions can be found on Moodle.
Prepare tutorial and support session questions before attending the

actual session.
Post any questions on Q&A Forum or send email at:

p.panagiotou@greewich.ac.uk
What’s next? Bond Valuation
See you all next week!

FINA1027 Lecture 5 Investment Appraisal II

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FINA1027 Lecture 5 Investment Appraisal II

Uploaded by

Copyright:

Available Formats

Lecture 5:

Investment Appraisal: Application & Risk

October 25, 2022

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 1 / 55

By the end of this session, you will be able to:

Understand the techniques to be employed in order to arrive at the best

Understand the rules to follow when investment appraisal is done in an

The distinction between risk and uncertainty.

Application of sensitivity analysis to investment projects.

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 2 / 55

Shareholder wealth is maximised if a company undertakes all possible

Two types of capital rationing:

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 3 / 55

May be imposed externally - external factors preventing a company from

- A covenant attached to an existing loan may not allow additional funds to

- Investors consider the company to be too risky.

- A downgrade in its credit rating.

- General situation of the economy or industry-wide factors limiting funds.

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 4 / 55

Soft capital rationing may be imposed internally by management (i.e., the

- Managers may decide against raising additional equity finance because

- Managers may decide against raising additional debt finance in order to

- Limited management skills available for a few projects.

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 5 / 55

Multi-period capital rationing: shortage of funds in more than one period.

The aim is to maximize the NPV earned per £1 invested in projects.

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 6 / 55

If a project is divisible (i.e. can be done in part):

- any fraction of the project may be undertaken

- Calculate the Profitability Index (see below);

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 7 / 55

The Profitability Index (PI) is defined as the PV of a project’s future CFs

PV of Future Cash Flows NPV

The investment decision rule for the PI is as follows:

This is consistent with the NPV approach.

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 8 / 55

Project Initial Investment Cash Inflows NPV Profitability

PIA = 1 + (15/110) = 1 + 0.15 = 1.15

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 9 / 55

Project Initial Investment Cash Inflows NPV Profitability Ranking

PIA = 1 + (15/110) = 1 + 0.15 = 1.15

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 10 / 55

But our available capital is £1,650.

PIA = 1 + (650 / 500) = 1 + 1.3 = 2.3

PIB = 1 + (715 / 650) = 1 + 1.1 = 2.1

PIC = 1 + (800 / 800) = 1 + 1.0 = 2.0

PID = 1 + (765 / 850) = 1 + 0.9 = 1.9

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 11 / 55

Investment NPV (£) Cumulative Investment (£)

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 12 / 55

If a project is non-divisible (i.e. cannot be done in part):

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 13 / 55

Project Initial Investment NPV

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 14 / 55

Project or Initial Investment NPV

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 15 / 55

Do not consider cash flows that would occur independently of the

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 16 / 55

5 Investment in working capital

costs related to feasibility studies

past salaries related to the project

Sunk costs should not be taken under consideration as these costs do

Panagiotis Panagiotou (Greenwich) Investment Appraisal II FINA1027 (Term 1) 18 / 55