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Group no: 06

Name

ID

Kamrun Nahar

18256

Swarna Kundu

18183

Debashis Mondal

18121

Sudipta Das

18150

Md. Jahidul Islam

18261

1.

Payback Period

2. Net present value (NPV)


3. Profitability Index

What is payback period?


The amount of time required for a
firm to recover its initial investment
in a project, as calculated from cash
inflows.

Decision Criteria
If the payback period is less than the
maximum acceptable payback
period,
Accept The Project.
If the payback period is greater than
the maximum acceptable period,
Reject The Project.

If used for comparing between two or


more projects, then accept the
project with lowest payback period.

Two scenarios can happen


Annuity
Mixed stream of cash flows

Annuity
In case of an annuity, where, there is
a series of equal payments at
regular intervals, the payback period
can be found by Dividing the initial investment by
the annual
cash flow.

Example

25000

25000

25000

25000

25000

-100,000
Project A
Payback period = Initial investment / annual cash flow
= 100,000/ 25000
= 4 years

If the companys maximum


acceptable payback period is 3.5
years, Project A will be Rejected (4
years PB).

Mixed stream of cash flows


Suppose the purchase of a new machine :
which costs 100,000 BDT
After-tax cash inflows :
TK 40,000 in the 1st year
TK 45000 in the 2nd year
TK 60000 in the 3rd year
TK 35000 in the 4th year
The firm has a policy of buying equipment only
if the payback period is 2 years or less.
Whether to buy or not?

Two Major Flaws


1. It ignores all cash flow after the
initial
cash outflow has been recovered.
2. It ignores the time value of money.

Discounted Payback Period


Calculates the time it takes to
recover the initial investment in
current or discounted amounts..
Incorporates time value of money by
adding up the discounted cash
inflows up to time 0, using the
appropriate discount rate, and then
measuring the payback period.

Lets consider the previous example with a


discount rate of 10%

Limitations
Like the payback period method, it
also ignores the cash flows after the
recovery of initial investment.

Net Present Value (NPV)


Discounts all the cash flows from a project back to time 0
using an appropriate discount rate, r:

A positive NPV implies that the project is adding value


to the firms bottom line and therefore when comparing
projects, the higher the NPV the better.
Financial management Reymond Brooks

Consider a project A in which initial


investment is TK 10,000 and is likely
to bring in after-tax cash inflows of
TK 4,000 in the first year, TK4,500 in
the second year, TK10,000 in the 3rd
year, and TK8,000 in the 4th year.

Example: Calculating NPV.


Using the cash flows for project, calculate its
NPV and indicate whether the investment should
be undertaken or not.
NPV A = -10,000 + 4,000/(1.10)+ 4,500/(1.10)2 +
10,000/(1.10)3+ 8,000/(1.10)4
= -10,000 + 3636.36 + 3719.01 +
7513.15+ 5,464.11
= 10,332.62
Since the NPV > 0, the project should be accepted.

Mutually Exclusive versus


Independent Projects
NPV approach useful for independent as well as mutually
exclusive projects.
A choice between mutually exclusive projects arises
when:
1. There is a need for only one project, and both projects
can fulfill that need.
2. There is a scarce resource that both projects need, and
by using it in one project, it is not available for the
second.
Higher positive NPVs would be preferred to lower NPVs.
Negative NPV projects are rejected. Decision is clear-cut.

Mutually Exclusive versus


Independent Projects
Example: Calculate NPV for choosing between mutually
exclusive projects.
In either case, assume that the cost of capital will be 10%.
The relevant annual cash flows with each option are listed below:
Year
Project A
Project B
0 -10,000 -12,500
1
4,000
4,400
2
4,500
4,800
3
10,000
11,000
4
8,000
9,500
Which one is the right project to choose?

Example: Calculate NPV for choosing between mutually


exclusive projects.
Since these are mutually exclusive options, the one with the
higher NPV would be the best choice.
NPV A = 10,332.62(just calculated)
NPV B = -12,500 + 4,400/(1.10) + 4,800/(1.10)2 +
11,000/(1.10)3 + 9,500/(1.10)4
= -12,500 + 4,000 + 3,966.94 + 8,264.46 + 6,488.63
= 10,220.03
Thus, the less expensive project is A with the higher NPV
(10,332.62 > 10,220.03) is the better option.
What would you rather have, 10,332.62 or 10,220.03?

Unequal Lives of
Projects
Firms often have to decide between
alternatives that are:
mutually exclusive,
cost different amounts,
have different useful lives, and
require replacement once their productive lives run
out.

In such cases, using the traditional NPV (single


life analysis) as the evaluation criterion can
lead to incorrect decisions, since the cash
flows will change once replacement occurs.

Under the NPV approach, mutually exclusive


projects with unequal lives can be analyzed by
using one of the following two modified
approaches:

1. Replacement Chain Method.


2. Equivalent Annual Annuity (EAA)

Example: Unequal lives.


Lets say that there are two machines available,
one lasts for 3 years while the other for 4 years.
The owner realizes that he will have to replace
either of these two machines with new ones when
they are at the end of their productive life, as he
plans on being in the business for a long time.
Using the cash flows listed below, and a cost of
capital is 10%.
which of the two machines he should choose.

Example : Unequal lives

Using the Replacement Chain method:


First you need determine a point in time where
both choices will be replaced at the same time.
Lowest common denominator here is 12 years
(note you replace the three year machine B in
years 3, 6, 9, and 12 while you replace the four
year machine A in years 4, 8, and 12). Hint: 3 x
4 = 12
Now assume the cash flows for 12 years with a
repetition of the prior machine continuing.

We assume that the annual cash flows are the same for each replication.

Total NPV

= 10, 332.62 + 10,332.62/(1.10) 4 +


10,332.62/(1.10)8
Total NPVA = 10,332.62 + $7,057.32 + 4,820.24
= 22,210.18
Total NPVB

= 8,367.21 + 8,367.21/(1.10)3 +
8,367.21/(1.10)6 + 8,367.21/(1.10)9
Total NPVB = 8,367.21+ 6,286.41+ 4723.07+ 3,548.51
= 22,925.20
Machine Bs NPV = 22,925.20 > Machine As NPV = 22,210.18
Choose Machine B

Profitability Index
If faced with a constrained budget choose projects
that give us the best bang for our buck.
The Profitability Index can be used to calculate the
ratio of the PV of benefits (inflows) to the PV of the
cost of a project as follows:
PI with standard cash flow = (NPV + Cost) /
Cost
In essence, it tells us how much money we are
getting per taka invested.

Example : Profitability Index


Year

Project A

Project B

-10,000

-7,000

5,000

9,000

7,000

5,000

9,000

2,000

NPV @ 10%

7,092.41

6,816.68

Example: PI calculation
Using the cash flows listed in our previous example,
and a discount rate of 10%, calculate the PI of each
project. Which one should be accepted, if they are
mutually exclusive? Why?
PIA = (NPV + Cost)/Cost = (17,092.41/10,000) =
1.71
PIB = (NPV + Cost)/Cost = (13,816.68/7,000) =
1.97
Choose Project B, Higher PI.

INTERNAL RATE OF RETURN


The IRR of a project is the discount rate which makes its
NPV equal to zero.
In the NPV calculation we assume that the discount rate
is known and determine the NPV.
In the IRR calculation, we set the NPV equal to zero and
determine the discount rate that satisfies this condition.
IRR is the value of r in the following calculation:
Investment =

WHY IRR
used in capital budgeting to measure profitability and investment.
used to evaluate the desirability of investments or projects.
enables firms capacity to manage projects or investment with IRR
that exceed the cost of capital.
It is an indicator of efficiency, quality and yield of an investment.
Acceptability of an investment is dependent if IRR > the minimum
acceptable rate of return.
comparison between different capital projects is the use of IRR.

ILLUSTRATION
To illustrate the calculation of IRR, consider the cash flows of a project being
considered by TECHTRON LTD
Year

Cash flow (100000)

30000

30000

40000

45000

The IRR is the value of r which satisfies the following equation:


100000= (30000/(1+r)^1) + (30000/(1+r)^2) + (40000/(1+r)^3) + (45000/(1+r)^4)
The calculation of r involves a process of trial and error. We try different values of r till we find
that the right hand side of the above equation is equal to 100000. Let us, to begin with, try r
= 15%
(30000/ (1+0.15) ^1) + (30000/ (1+0.15) ^2) + (40000/ (1+0.15) ^3) + (45000/ (1+0.15)
^4) = 100,802.
Since 100802 > 100000, we can increase the value of r from 15 to 16 %. (in general, a higher
r lowers and a smaller r increases the right hand side value). The right hand side becomes:

Continue.
(30000/ (1+0.16) ^1) + (30000/ (1+0.16) ^2) + (40000/ (1+0.16) ^3) + (45000/ (1+0.16)
^4) = 98,641.
Since this value is less than 100000, we conclude that the value of r lies between 15 or 16
%.
If a more refined estimate of r is needed, use of the two closest rate of return.
Step 1.

(NPV/ 15%)
802
(NPV/ 16%)
(1359)
Step 2. find the sum of the absolute values of the net present values obtained in step 1:
802+1359= 2161
Step 3. calculate the ratio of the NPV of the smaller discount rate, identified in step 1, to
the sum obtained in step
2:
802/2161= 0.37
Step 4. add the number obtained in step 3 to the smaller discount rate:
15+0.37= 15.37% (IRR).

DECISION RULE FOR IRR:

Accept: if the IRR is greater than the cost


of capital.
Reject: if the IRR is less than the cost of
capital.

MODIFIED IRR
TheModified Internal Rate of Return(MIRR) is afinancialmeasure of
aninvestment's attractiveness.It is used incapital budgetingto rank
alternative investments of equal size. As the name implies, MIRR is a
modification of theinternal rate of return(IRR) and as such aims to
resolve some problems with the IRR.

Problems with the IRR

While there are severalproblems with the IRR, MIRR resolves two of them.
Firstly, when the cash flows of the project are not conventional or when
two or more projects are being compared to determine which one is the
best.
Secondly, IRR cannot distinguish between lending and borrowing.
Thirdly, IRR is difficult to apply when short term interest rates differ from
long term interest rates.
finally, more than one IRR can be found for projects with alternating
positive and negative cash flows, which leads to confusion and ambiguity.
MIRR finds only one value.

CALCULATION OF THE MIRR

wherenis the number of equal periods at the end of which the cash
flows occur (not the number of cash flows),PVispresent value(at the
beginning of the first period),FVis future value(at the end of the last
period).

illustration
Year

Cash flow (1000)

(4000)

5000

2000

If an investment project is described by the sequence of cash flows, then IRR r is


given by:

In this case, the answer is 25.48% (with this conventional pattern of cash flows,
the project has a unique IRR).
To calculate the MIRR, we will assume a finance rate of 10% and a reinvestment
rate of 12%. First, we calculate the present value of the negative cash flows
(discounted at the finance rate):

CONT
Second, we calculate the future value of the positive cash flows (reinvested
at the reinvestment rate):

Third, we find the MIRR:

The calculated MIRR (17.91%) is significantly different from the IRR (25.48%).

EVALUATION
MIRR is superior to the IRR in two ways:
1.MIRR assumes that projects cash flows are reinvested
at the cost of capital whereas IRR assumes that project
cash flows are reinvested at the projects own IRR.
2.The problem of multiple rates does not exist with MIRR.
Thus, MIRR is a distinct improvement over the regular
IRR.
It is as good as NPV in choosing mutually exclusive
projects.

INCREMENTAL ANALYSIS
a technique or approach that can be used with NPW,
EAW and later with IRR and cost/ benefit to determine
if an incremental expenditure should be made.
Incremental analysis can also be used when you
are already incurring an expense.
(e.g; DSL internet service)
and you are trying to determine if it is a good
decision to spend additional funds.(e.g; satellite or
cable)

WHY IA FOR COMPETING PROJECTS


Assume that an MIRR of 16% per year is required, and $85 000 is available
to invest:

Project A requires $50 000 upfront to obtain an IRR of 35% per year.

Project B requires an $85 000 first cost and returns an IRR of 29% per
year.

What could we do with the un-invested money from Project A? ($35


000)

It would be reasonable to invest the remaining $35 000 at the MIRR:

Overall IRRA = 50 000(.35) + 35 000(.16)/ 85000


= 27.2% per year
Project B returns an IRR of 29% per year on ALL the money available to
invest.

IRR INCREMENTAL ANALYSIS


Rank projects from lowest to highest initial cost
Eliminate any projects with IRR < MIRR
Let A & B two projects with IRR and MIRR
Starting from the least expensive project to the next most expensive, justify each
incremental investment

IRR(A) < MIRR(B) Accept B project & Reject A Project

IRR(A) = MIRR(B) Indifferent


IRR(A) > MIRR(B)
Project

Reject B project & Accept A

ACCOUNTING RATE OF RETURN


The ARR also referred to as the average rate of return on investment, is a
measure of profitability which relates income to investment, both measured
in accounting terms and is defined as:
profit after tax
book value of the investment

since income and investment can be measured in different ways, there can
be a very large number of measures for ARR.

MEASURES OF ARR
A.Average
B.Average
C.Average
D.Average

income
income
income
income

after
after
after
after

tax/ Initial investment.


tax/ Average investment.
tax but before interest/ Initial investment.
tax but before interest/ Average investment.

E. Average income before interest and taxes/ Initial investment.


F. Average income after tax but before interest/ Average investment.
G. (Total income after tax but before dep.- initial investment)/ (Initial
investment2) year.

SLASH(/) USED THOSE SLIDES INDICATE DIVISION SIGN

SOME VIRTUES OF ARR:

1.It is simple to calculate


2.Based on accounting information which
is readily available
3.It considers benefits over the entire life
of the project

SHORTCOMINGS ARE:
1.It is based upon accounting profit, not cash flow
2.It does not take into account the time value of money.
EVALUATION:
the higher the ARR, the better the project.
In general ARR > pre specified cut off rate of return(between
15 & 30%) are accepted, others are rejected.
. The computation of various measures of ARR with
reference to a hypothetical project.
Please see exhibit 8.10, chapter 8, PRASANNA CHANDRA,
PROJECTS.

Economic Analysis
A systematic approachto determining the
optimum use of scarce
resources. It takes
intoaccounttheopportunity costsof
resourcesemployedandattemptstomea
sureinmonetaryterms the private
andsocial costs andbenefits of
aprojectto the community or economy.

Types of Economic Analysis

Cost benefit
analysis(CBA)
Cost Effective
Analysis(CEA)
Cost Utility
Analysis(CUA)

Cost benefit analysis(CBA)


A cost-benefit analysis (CBA) is a
systematic process for calculating
and comparing benefits and costs of
a project or decision. A CBA helps
predict whether the benefits of a
project or decision outweigh its costs,
and by how much relative to other
alternatives.

Purpose of CBA
A CBA has two purposes:
1. To determine if the project or
decision is a sound.
2. To provide a basis for comparing
projects or decisions. It involves
comparing the total expected cost of
each option against the total
expected benefits.

Principles of CBA
Common unit of measurement
Representation of customers or
producers valuation
Benefit measurement by market
choice
No double counting of benefits or
costs
Some measurement of benefit may
consider human factor

Net benefit

Cost Benefit Ratio

=Total BenefitTotal cost


=160000-114000
=46000

= benefit/ cost
=160000/11400
0
=1.40

Let us consider a project:


Cost of capital 12%, initial investment 100,000
Benefits:
year1 - 25000
year2- 40000
year3- 40000
year4- 50000.
Here, the BCR measures for this project got by dividing
present value of benefits by the initial value of
investment. i.e: PV factor: (1+i)^n, then we get BCR
1.145.
And NBCR= BCR-1=0.145.
When BCR
NBCR
RULE IS
Decision rule
>1

>0

ACCEPT

=0

=O

INDIFFERENT

<1

<0

REJECT

(project chapter 8 by Prosonnya Chandra)

Cost Effective Analysis(CEA)


Cost-effectiveness analysis(CEA) is a
form ofeconomic analysisthat
compares the relative costs and
outcomes (effects) of two or more
courses of action.

CBA Vs CEA
CBA

CEA

Considers only
monetary value of
output.
Highly used in
industrial or technical
sector.
Focus on monetary
value.
Cost is a denominator

Considers both
monetary and non
monetary value of
output.
Highly used in
Training and personnel
programs.
Focus on no of units.
Cost is a numerator

Math on CEA
Albert healthcare
Intervention

QALY Gained

Net Cost

20

$500

30

$2000

25

$1000

Intervention

QALY Gained

Net Cost

20

$500

25

$1000

30

$2000

CE ratio
Intervention

QALY Gained
Net Cost
per
day(effectiven
ess)

CE ratio
(Net Cost/QALY
Gained)

20

$500

$25

25

$1000

$50

30

$2000

$67

X should be covered first because it has the best


(lowest) cost-effectiveness ratio

ICER
Shipment to new option(From X to Z)
incremental cost = (Cost Z Cost X) = $1000-$500
= $500
incremental benefit = (QALYs Z QALYs X) = 25
QALYs -20 QALYs = 5 QALYs

= (Cost Z Cost X)/ (QALYs Z QALYs X)=


($1000-$500)/( 25 QALYs -20 QALYs) = $500/5
QALYs = $100/QALY.
This means if we chose to implement
intervention Z in place of intervention X, it would
cost $100 per unit additional health benefit that

Cost Utility Analysis(CUA)


Cost-utility
analysis
is
used
to
determine cost in terms of utilities,
especially quantity and quality of life. It
is often used in health appraisals. In a
CUA, costs are expressed in monetary
terms and outcomes/ benefits are
expressed in utility terms e.g.
outcomes are often defined in quality
adjusted life years (QALYs).

Mathematical Problem

Equivalent Annual Annuity/Cost

The equivalent annual annuity approach (EAA) is one of


two methods used incapital budgetingto compare
mutually exclusiveprojects with unequal lives.
The equivalent annualannuity(EAA) approach calculates
the constant annualcash flowgenerated by a project
over its lifespan if it was an annuity. Thepresent valueof
the constant annualcash flowsis exactly equal to the
project'snet present value.

Breaking Down 'Equivalent Annual Annuity Approach

The EAA approach uses a three-step process to


compare projects:
1.Calculate each project's NPV over its lifetime.
2.Compute each project's EAA, such that the present
value of the annuities is exactly equal to the project
NPV
3.Compare each project's EAA and select the one with
the highest EAA.

CALCULATION
NET PRESENT VALUE

EAA =

1-( 1+ discount rate)^ life of


project
discount rate

Decision Rule

The project with higher EAA is


preferred

Application
Assessing alternative projects of unequal lives.
Determining the optimum economic life of an asset.
Assessing whether leasing an asset would be more economical than
purchasing it.

Assessing whether increased maintenance costs will economically


change the useful life

of an asset.

Calculating how much should be invested in an asset in order to


achieve a desired result.

APPLICATION

Comparing to estimated annual cost savings.

Estimating the cost savings required to justify the

purchase of new equipment.

Determining the cost of continuing with existing

equipment.

To calculate the optimum life of holding on to the

asset.

Worked out Example


Combustion Systems is engaged in development of car racing games. The company has to
choose between two games: Outback and Accelerate. Outback introduces a revolutionary
technology called SRP and is expected to stay fresh for 5 years. Accelerate is more of a low
cost traditional racing game and is sort of an upgrade to Nitrous, the current best-seller.
Accelerate is expected to generate sales for only 2 years.
Following is the schedule of each project's cash flows:
Year
Outback

0
1
(150000 500000
0)
Accelerate (800000 800000
)

2
600000

3
800000

4
300000

5
200000

200000

Since Outback is revolutionary, it involves hiring external consultants to help with


optimization and testing of the game, and hence the higher initial investment. Outback has
higher risk which warrants use of a 10% discount rate as compared to a rate of 8%
applicable to Accelerate.
Which project the company should go ahead with?

Solution:

Outback

Accelerate

Cash flows 10%


discount
factor

Present
value

Cash flows 8%
discount
factor

(15,000,00
0)

1.0000

(15,000,00 (8,000,000
0)
)

5000,000

0.9091

4545500

6,000,000

0.8264

8,000,000
3,000,000
2,000,000

0.7513
0.6830
0.6209
NPV

year

Present
value

1.0000

(8,000,000
)

8,000,000

0.9259

7,407,407

4,958,678

2,000,000

0.8573

1,714,678

6,010,518
2,049,040
1,241,843
3,805,534

NPV

1,122,085

3
4
5

The second step involves finding the cash flows occurring at each
year end that would equal the relevant net present value when
discounted at the relevant discount rate.

EAA(Outback)=

3805534
(1-(1+10%)^5)/10%

EAA(Accelerate)=
629231

1003890

1122085

(1-(1+8%)^2/8%

Since Outback has higher equivalent annual annuity, it is the clear winner. The company
should work on Outback.

A Practical Example(cost method)


option

Machine A

Machine B

Investment cost

$50,000

$150,000

Expected lifetime

3 years

8 years

Annual maintenance cost $13,000

$7,500

Equivalent annual cost

150000/A8,5+7500=30708

50000/A3,5+13000= 31360

Cost of capital is 5%

The conclusion is to invest in machine B


since it has a lower EAC.

A (n,i) is the present value


annuity factor
=(1-(1+i)^n)/i

REAL OPTIONS VALUATION


Real Options Valuation, also often termedreal options
analysis, (ROV or ROA) appliesoption valuation
techniquestocapital budgeting decisions.

Areal optionitself, is the right but not the


obligation to undertake certain business initiatives,
such as deferring, abandoning, expanding, staging, or
contracting a capital investment project.

EXAMPLE
For example, the opportunity to invest in the
expansion of a firm's factory, or alternatively to sell
the factory, is a realcallorput option, respectively.
Real options analysis, as a discipline, extends from
its application incorporate finance, todecision
making under uncertaintyin general, adapting the
techniques developed for financial optionsto "reallife" decisions.

BREAKING DOWN OF REAL OPTION


Investment decision can be treated as the exercising of an option.
Firm has option to invest.
Need not exercise the option now can wait for more
information.
If investment is irreversible (sunk cost), there is an opportunity
cost of investing now rather than waiting.
Opportunity cost (value of option) can be very large.
The greater the uncertainty, the greater the value of the firms
options to invest, and the greater the incentive to keep these
options open.
Note that value of a firm is value of its capital in place plus the
value of its growth options.

OPTION BASED VALUATION


Valuation Inputs:
The options underlying is the project
in question. It is modelled in terms of
Spot price
volatility: 1) price/Historical
2) implied volatility
Dividends

OPTION CHARACTERISTICS
1)strike price
2)Option term
3)Option style & option exercise:

Option to contract
Option to abandon
Option to extract

EXAMPLES
R&Dmanagers can use Real
Options Valuation to help them
allocate their R&D budget among
diverse projects;
a non business example might
be the decision to join the work
force, or rather, to forgo several
years of income to
attendgraduate school

"Investment
Example"
Consider a firm that has the option to
invest in a new factory. It can invest
this year or next year. The question
is: when should the firm invest? If the
firm invests this year, it has an
income stream earlier. But, if it
invests next year, the firm obtains
further information about the state of
the economy, which can prevent it
from investing with losses.

EXAMPLE CONT
Investment Example

The firm knows itsdiscounted cash flowsif it invests


this year: 5M. If it invests next year, the discounted
cash flows are 6M with a 66.7% probability, and 3M
with a 33.3% probability. Assuming a risk neutral rate
of 10%, futurediscounted cash flowsare, in present
terms, 5.45M and 2.73M, respectively. The investment
cost is 4M. If the firm invests next year, the present
value of the investment cost is 3.63M.
Following thenet present valuerule for investment,
the firm should invest this year because
thediscounted cash flows (5M) are greater than the
investment costs (4M) by 1M. Yet, if the firm waits for
next year, it only invests if discounted cash flows do
not decrease. If discounted cash flows decrease to
3M, then investment is no longer profitable. If, they
grow to 6M, then the firm invests. This implies that the
firm invests next year with a 66.7% probability and
earns 5.45M - 3.63M if it does invest. Thus the value to
invest next year is 1.21M. Given that the value to
invest next year exceeds the value to invest this year,
the firm should wait for further information to prevent
losses. This simple example shows

howthenet present valuemay lead the


firm to take unnecessary risk, which could
be prevented by real options valuation.

dont be bored just read through

Staged investments are quite often in the pharmaceutical,


mineral, and oil industries. In this example, it is studied a staged
investment abroad in which a firm decides whether to open one
or two stores in a foreign country. This is adapted from"Staged
Investment Example"
The firm does not know how well its stores are accepted in a
foreign country. If their stores have high demand, the discounted
cash flowsper store is 10M. If their stores have low demand,
thediscounted cash flowsper store is 5M. Assuming that the
probability of both events is 50%, the expecteddiscounted cash
flowsper store is 7.5M. It is also known that if the store's demand
is independent of the store: if one store has high demand, the
other also has high demand. The risk neutral rate is 10%. The
investment cost per store is 8M.
Should the firm invest in one store, two stores, or not invest?
Thenet present valuesuggests the firm should not invest: the
net present value is -0.5M per store. But is it the best alternative?
Following real options valuation, it is not: the firm has the real
option to open one store this year, wait a year to know its
demand, and invest in the new store next year if demand is high.
By opening one store, the firm knows that the probability of high
demand is 50%. The potential value gain to expand next year is
thus 50%*(10M-8M)/1.1 = 0.91M.
The value to open one store this year is 7.5M - 8M = -0.5. Thus
the value of the real option to invest in one store, wait a year,
and invest next year is 0.41M. Given this, the firm should opt by
opening one store. This simple example shows that

Stage investment

anegativenet present valuedoes not imply that


the firm should not invest.

SWITCHING VALUE/COST
Switching costs are the negative costs that a consumer incurs as a
result of changing suppliers,brandsor products.
It may be..
Inmutual funds, the process of transferring an investment from one
fund to another.
In securities, the process of liquidating a position in exchange for
other securities with better prospects for growth, yields orcapital
gains.

BREAKING DOWN 'SWITCHING COSTS'

Sustainable companies usually try to employ


strategies that incur some sort of high cost in order to
dissuade customers from switching to a competitor's
product, brand or services.
For example, many cellular phone carriers charge very
highcancellationfees for canceling a contract. Cell
phone carriers do this in hopes that the costs involved
with switching to another carrier will be high enough
to prevent their customers from doing so.

Cont..
1.Investors mayswitchtheir assets between funds in
the same family or into a different family entirely.

2. When investors switch securities, they essentially


use the cash received from theliquidationof their
initial securities to purchase new securities.

Minimize switching costs to maximize value

If you want to be abadproduct manager, build


the best product and assume that the
customers will come.
If you want to be agoodproduct
manager,understand relevant switching costs
and attempt to reduce them as much as possible
to improve customer acquisition and perceived
value.

Switching cost:

In most cases, the main cost is explicit


the price of the product to purchase.
These switching costs take multiple
different forms:
learning cost
Opportunity cost
implementation cost
conversion cost

Multinational Capital Budgeting

Multinational Capital
Budgeting
Like domestic capital budgeting, this focuses
on the cash inflows and outflows associated
with prospective long-term investment projects
Capital budgeting follows same framework as
domestic budgeting
Identify initial capital invested or put at risk
Estimate cash inflows, including a terminal value or
salvage value of investment
Identify appropriate discount rate for PV calculation
Apply traditional NPV or IRR analysis

Factors to Consider in Multinational Capital


Budgeting

Exchange rate fluctuations. Different

scenarios should be considered


together with their probability of
occurrence.
Inflation.

Although
price/cost
forecasting
implicitly
considers
inflation, inflation can be quite
volatile from year to year for some
countries.

Factors to Consider in Multinational


Capital Budgeting
Financing arrangement. Financing costs

are usually captured by the discount


rate. However, many foreign projects are
partially financed by foreign subsidiaries.
Blocked

funds. Some countries may


require that the earnings be reinvested
locally for a certain period of time before
they can be remitted to the parent.

Factors to Consider in Multinational


Capital Budgeting
Uncertain

salvage value. The salvage value


typically has a significant impact on the projects
NPV, and the MNC may want to compute the
break-even salvage value.

Impact of project on prevailing cash flows. The

new investment may compete with the existing


business for the same customers.
Host government incentives. These should also

be considered in the analysis.

Capital Budgeting from the Parent


Firms Perspective
One recipe for international decision
makers:
1. Estimate future cash flows in
foreign currency.
2. Convert to the home currency at
the predicted exchange rate.
3. Calculate NPV using the home
currency cost of capital.

Capital Budgeting from the Parent


Firms Perspective: Example
A U.S.-based MNC is considering a
European opportunity.
To simplify the example
There
There
There
There

is no incremental debt
is no incremental depreciation
are no concessionary loans
are no restricted funds

Capital Budgeting from the Parent


Firms Perspective: Example
A U.S. MNC is considering a European
opportunity. The size and timing of the
after-tax cash flows are:
600
200
500
300

The inflation rate in the euro zone is = 3%


The inflation rate in dollars is $ = 6%
The business risk of the investment would lead the U.S.based firm to demand a return of Kud = i$ = 15%.

Capital Budgeting from the Parent


Firms Perspective: Example
600

200

500

300

$1.25
The current exchange rate is S0($/) =

Is this a good investment from the perspective of the


U.S. shareholders?
To address that question, lets convert all of the cash
flows to dollars and then find the NPV at i$ = 15%.

Capital Budgeting from the Parent


Firms Perspective: Example
$750
600

200

500

300

$1.25 = $750
CF0 = (600) S0($/) =(600)

Finding the dollar value of the initial cash


$1.25
flow is easy; convert at the spot rate: S0($/) =

Capital Budgeting from the Parent


Firms Perspective: Example
$750
600

$257.28
200

500

300

The exchange rate expected to prevail in the first year, S1($/),


can be found as:
1 + $
1.06
$1.25

S1($/) = 1 + S0($/) =
= $1.2864/

1.03

CF1 = 200 S1($/) = 200 $1.2864/ = $257.28

Capital Budgeting from the Parent


Firms Perspective: Example
$750
600

$257.28
200

$661.94
500

300

CF2=

1.06
1.03

1.06
1.03

$1.25

500 = $661.94

Capital Budgeting from the Parent


Firms Perspective: Example
$750
600

$257.28
200

$661.94
500

CF3=

1.06
1.03

1.06
1.03

1.06
1.03

$408.73
300

$1.25

300 = $408.73

Capital Budgeting from the Parent


Firms Perspective: Example
$750

$257.28

$661.94

$408.73

Find the NPV using the cash flow @ interest rate i$ = 15%:
CF0 = $750
CF1 = $257.28
CF2 = $661.94
CF3 = $408.73

= 15

NPV = $242.99

Capital Budgeting from the Parent


Firms Perspective: Alternative
Another recipe for international decision
makers:
1. Estimate future cash flows in foreign
currency.
2. Estimate the foreign currency discount
rate.
3. Calculate the foreign currency NPV using
the foreign cost of capital.
4. Translate the foreign currency NPV into
dollars using the spot exchange rate

Foreign Currency Cost of Capital


Method
600

200

500

300

= 3%
i$ = 15%

Lets find i and use that on the euro


cash flows to find the NPV in euros.

Then translate the NPV into dollars


$ = 6%
at the spot rate.
$1.25
The current exchange rate is S0($/) =

Finding the Foreign Currency Cost of


Capital: i
Recall that the Fisher Effect holds that

(1 + e) (1 + $) = (1 + i$)
real
rate

inflation
rate

nominal
rate

So, the real rate in the U.S

(1 + e) =

(1 + i$)
(1 + $)

Finding the Foreign Currency Cost of


Capital: i
If Fisher Effect holds here and abroad then

(1 + e$) =

(1 + i$)
(1 + $)

and

(1 + e) =

(1 + i)
(1 + )

If the real rates are the same in dollars and euros (e = e$)

We have a very useful parity condition:

(1 + i$)
(1 + $)

(1 + i)
(1 + )

Finding the Foreign Currency Cost of


Capital: i
If we have any three of these variables, we can find the fourth:

(1 + i$)
(1 + $)

(1 + i)

In our example, we want to find i

(1 + )

(1 + i) =
i =

(1.15) (1.03)
(1.06)

(1 + i$) (1 + )
(1 + $)

1
i = 0.1175

International Capital Budgeting:


Example
600

200

500

300

Find the NPV using the cash flow menu and i = 11.75%:
CF0 = 600
CF1 = 200
CF2 = 500
CF3 = 300

= 11.75

NPV = 194.39
$1.25 = $242.99
194.39

600

200

500

300

1
3
2
200
500
300
=
194.39
+
+
NPV = 600 +
1.1175
(1.1175)2
(1.1175)3

$750

$257.28

194.39

$1.25 = $242.99

$661.94

$408.73

1
3
2
$257.28 $661.94
$408.73
= $242.99
+
+
NPV = $750 +
2
3
1.15
(1.15)
(1.15)

International Capital
Budgeting
We have two equally valid approaches:
Change the foreign cash flows into dollars at
the exchange. Find the $NPV using the
dollar cost of capital.
Find the foreign currency NPV using the
foreign currency cost of capital. Translate
that into dollars at the spot exchange rate.

If we watch our rounding, well get


exactly the same answer either way.
Which method you prefer is your choice.
18-112

Computing IRR
Recall that a projects Internal Rate of
Return (IRR) is the discount rate that
gives a project a zero NPV.
NPV = 600 +

200

1+IRR
IRR = 28.48%

NPV = $750 +

$257.28
1+IRR$

IRR$ = 32.23%
18-113

500

(1+IRR)

$661.94
(1+IRR$)

300

(1+IRR)
$408.73
(1+IRR$)

= 0

= $0

Computing IRR
Easily done with the IRR key
NPV = 600 +
CF0 = 600

200
1+IRR

500
(1+IRR)

300
(1+IRR)

CF2 = 500
18-114

= 0

IRR = 28.48%

CF1 = 200
CF3 = 300

IRR = 28.48%

Computing IRR
Easily done with the IRR key
NPV = $750 +

$257.28
1+IRR$

CF0 = $750

$661.94
(1+IRR$)

$408.73
(1+IRR$)

CF2 = $661.94
18-115

= $0

IRR$ = 24.85%

CF1 = $257.28
CF3 = $408.73

IRR = 32.23%

Converting from IRR$ to IRR


Use the same IRP and PPP conditions
that we used to convert from one
discount rate to another.

1+IRR$

(1 + $)

(1+IRR$) =

1+IRR

(1 + )

In our example, it was easy to find IRR


Finding IRR$ without converting all cash
flows into dollars is straightforward:

(1+IRR)(1 + $)
(1 + )

= 3%, $ = 6%

18-116

i =

(1.2848)(1.06)
(1.03)

IRR$ = 32.23%

Converting from IRR$ to IRR


Use the same IRP and PPP conditions
that we used to convert from one
discount rate to another.

1+IRR$

(1 + $)

(1+IRR$) =

1+IRR

(1 + )

In our example, it was easy to find IRR


Finding IRR$ without converting all cash
flows into dollars is straightforward:

(1+IRR)(1 + $)
(1 + )

= 3%, $ = 6%

18-117

i =

(1.2848)(1.06)
(1.03)

IRR$ = 32.23%

FOR MORE DETAIL & EXAMPLE

BROWSE WIKIPEDIA AND


INVESTOPEDIA
SEE PRASANNA CHANDRA, PROJECTS,
8TH EDITION
SEE GITMAN, MANAGERIAL FINANCE,
8TH EDITION
SEE ROSS, WESTERFIELD, JEFFE,
CORPORATE FINANCE, 7TH EDITION

Q&A