Management : Planning and

Decision-making
Salim Afzal Shawon, CFA
Key Managerial Decisions
For successful running of any business,
the management has to make plans and
decisions
Three major areas in managerial decisions-
Capital Structure - From where and how to
get funds?
Investment (Capital Budgeting) - Where and
how to invest the funds?
Working Capital Management - How to
manage funds in regular operation?
Investment Decision and Evaluation
The process of
◦ analyzing alternative long term investments
◦ making long-term investment decisions (acquire, sell etc.).

Also known as Capital Budgeting

◦ Capital Budget - The list of planned investment projects.

Examples:
◦ Plant Expansion
◦ Installing a new equipment
◦ Office Renovation
Investment Decision and Evaluation
Why These Decisions are important?
◦ Large amounts of money are usually involved
◦ Decision may be difficult or impossible to reverse
◦ Investment involves a long-term commitment
◦ Incorporates significant Risk

Decision Goal –
◦ choose the project with the most profitable return on
available funds
How do we decide if
an investment
project should be
accepted or
rejected?
Necessary Concepts
Opportunity Cost: What else could be done with the
available fund and what that will earn?
◦ Example: You have 10000 cash. You can keep it in pocket or
deposit at bank @ 10% interest for a year. If you keep it in
pocket, then your opportunity cost is the lost interest you
could've made by deposit the money in bank.
Rate of required return: What % minimum return
would be needed to earn from an investment?
◦ Usually tied to opportunity cost
◦ Can change over risk & return profile of investment
◦ Example: You earn 10% from Bank FDR. If you would like to
invest in any other areas, what would be the minimum % return
would you ask for given your existing earning from bank?
Necessary Concepts
Time Value of Money: Value of money at different time
considering return generated from the money over time
◦ Example: You've BDT 100 at Bank now @ 10% interest. Then
 At year 1, you have BDT 110 at bank
 At year 2, you've BDT 121 at bank
◦ Isn't having 100 today at bank for two years equal to having
121 two year later?
Discounting: the mechanism used to account for the
time value of money
◦ Converts future cash flows into today’s equivalent value called
present value (PV)
◦ Example:
 PV of BDT 121 in year 2 @ 10% = 121/(1+0.10)2
Necessary Concepts
Understanding Cashflows
◦ Sunk Cost : Cost already incurred
 Not considered for Decision making
◦ Incremental Cashflows : Cashflows that result exclusively from
taking an investment decision
 Independent from other activities of the firm
 Relevant for Decision making
 Example:
◦ ABC company would like to buy a new machine. The machine
would save operating costs by 10,000 per year. The machine will be
set up on a land the company bought 5 years ago at 200,000. current
market value of the land will be 500,000. what are the cashflows to
be considered here for investment decision on the machine?
 Sunk Cost = Land purchase cost [not relevant here]
 Incremental Cashflows= BDT 10,000 savings per year
 Investment Cash flows: Time Line
Illustration
One-Period Investment

Two-Period Investment, No
Intermediate Cash Flow

Two-Period Investment
with Intermediate Cash
Flow
Multiple-Period Investment

9
Decision-making Criteria in Capital
Budgeting
Non – DCF Techniques :
◦ Accounting Rate of Return (ARR)
◦ Pay Back Period (PB)
DCF Techniques :
◦ Discounted Pay Back Period (DPB)
◦ Net Present Value (NPV)
◦ Profitability Index (PI)
◦ Internal Rate of Return (IRR)

10
Decision Rule
All of these techniques
attempt to compare the
costs and benefits of a COSTS
project
The over-riding rule of
capital budgeting is to
accept all projects for
which the cost is less
than, or equal to, the
benefit: BENEFITS
◦ Accept if: Cost £ Benefit
◦ Reject if: Cost > Benefit
 Average accounting return (AAR)

Average Net Income

AAR 
Average Book Value

◦ Note: Average book value depends on how the

asset is depreciated.
Requires a target cut-off rate
Decision rule:

◦ AAR > target rate, Accept the project

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12
Computing AAR for the project
Sample project data:
◦ Year 0: CF = -165 000
◦ Year 1: CF = 63 120 NI = 13 620
◦ Year 2: CF = 70 800 NI = 3 300
◦ Year 3: CF = 91 080 NI = 29 100
◦ Average book value = $72 000
Required average accounting return = 25%
Average net income:
 ($13 620 + 3300 + 29 100) / 3 = $15 340
AAR = $15 340 / 72 000 = .213 = 21.3%
Do we accept or reject the project?
Advantages Disadvantages

 Easy to calculate  Not a true rate of return

 Needed information usually
available
 Time value of money
ignored
 arbitrary benchmark cut-off
rate
 Based on accounting data
not cash flows

Pros & Cons of AAR

 Payback Period (PB)
Length of time until Example:
initial investment is ◦ Company X is
recovered investing into Project A
some specified target with BDT 1,00,000
initial investment.
is required ◦ Cashflow from Project
Decision rule: A will be BDT 40,000
◦ PB < target period, per year for 5 Years.
Accept the project ◦ It would take 2.5years
to recover Initial
Y0 Y1 Y2 Y3 Y4 Y5 investment. Hence PB
(100000) 40000 40000 40000 40000 40000
= 2.5Years
Advantages
 Easy to understand
 Adjusts for uncertainty of
later cash flows
 Biased towards liquidity
Pros & Cons of PayBack Period
Disadvantages
 Asks the wrong question
 Ignores time value of money
 Arbitrary cut-off point
 Ignores cash flows after payback
 Biased against long-term
projects, such as research and
development, and new projects
 May encourage excessive
investment in short-lived
projects
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Discounted Pay Back Period (DPB)
the amount of time, in years, for the discounted
future cash inflows to cover the original investment
outlay
Considers time value of money
Possess all other weaknesses of PB

In the previous example, assuming 10% discount

rate, PV of cashflows would be
Y0 Y1 Y2 Y3 Y4 Y5
(100,000) 36,364 33,058 30,053 27,321 24,837

DPB = 3.02 years

Net Present Value
 Most important decision technique
 Net present value (NPV) = PV of Cash inflows – PV
of Cash outflows
n
FCFt
NPV    IO
t 1 1  k 
t

 DecisionRule:
◦ NPV ≥ 0, Accept
 Computation
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19
Sample project data
 You are looking at a new project and have estimated
the following cash flows, net income and book
value data:
◦ Year 0: CF = -165 000
◦ Year 1: CF = 63 120 NI = 13 620
◦ Year 2: CF = 70 800 NI = 3 300
◦ Year 3: CF = 91 080 NI = 29 100
◦ Average book value = $72 000
 Your required return for assets of this risk is 12%.
 Computing NPV for the project
Using the formula:

n
CFt
NPV  
t 0 (1  R ) t

NPV = -165 000/(1.12)0 + 63 120/(1.12)1 + 70 800/(1.12)2 +

91 080/(1.12)3 = 12 627.41

Can also be computed in MS Excel using NPV function

Additive Property of NPV
 If one project has an NPV of $100,000 and another an NPV of
$50,000, the two projects have a combined NPV of $150,000
◦ Assuming that the two projects are Independent (no Side
Effects)
 An investment’s positive NPV is a measure of value creation to the
firm’s owners only if the project proceeds according to the
budgeted figures
◦ Consequently, from the managers’ perspective, a project’s positive NPV
is the maximum present value that they can afford to “lose” on the
project and still earn the project’s cost of capital

NPV(A+
NPV(A) NPV(B)
B)
Limitations of Net Present Value
 Ignores opportunities to make changes to projects over time
(Flexibility)
 A project that can adjust easily and at a low cost to significant
changes such as:
◦ Marketability of the product
◦ Selling price
◦ Risk of obsolescence
◦ Manufacturing technology
◦ Economic, regulatory, and tax environments
 Will contribute more to the value of the firm than indicated by its NPV
 Will be more valuable than an alternative project with the same NPV, that cannot be
altered as easily and as cheaply
 A project’s flexibility is usually described by Managerial Options
or Real Options
 Profitability Index (PI)

 Also known as Benefit/Cost Ratio

 The profitability index =total PV of future cash inflows /
total PV of Cash Outflows
n
FCFt

t 1 1  k 
t
PI 
IO
 This index is used as a means of ranking projects in
descending order of attractiveness.
 Decision rule: If PI ≥ 1.00, accept the project.
Advantages Disadvantages

 Closely related to NPV,  May lead to incorrect

generally leading to decisions in comparisons of
identical decisions mutually exclusive
 Easy to understand and investment
communicate
 Useful when available
investment funds are
limited

Pros & Cons of Profitability Index

Internal Rate of Return
Discount rate that exactly equates present
value of expected benefits to cost (drives
NPV to zero)
Find this discount rate by trial and error
Decision Rule:
◦ IRR> Required Rate of Return, Accept
Advantages Disadvantages

 Knowing a return is  Can produce multiple

intuitively appealing answers
 It is a simple way to  Cannot rank mutually
communicate the value of a exclusive projects
project to someone who  Reinvestment assumption
doesn’t know all the flawed
estimation details  Unreliable for non-
 If the IRR is high enough,
conventional cash flows
you may not need to
estimate a required return

Pros & Cons of IRR

Choosing the Best Technique
The ideal evaluation method should:
◦ include all relevant cash flows that occur during the
life of the project,
◦ consider the time value of money, and
◦ incorporate the required rate of return on the project.
◦ Should provide best choice in terms of value addition
The ideal investment decision making technique in
majority of cases is Net Present Value.
Whenever there is a conflict between NPV and
another decision rule, you should always use NPV.
Practice
 Consider an investment that costs $100,000 and has a cash inflow
of $25000 every year for 5 years. The required return is 9% and
required payback is 4 years.
◦ What is the payback period?
◦ What is the NPV?
◦ What is the IRR?
◦ Should we accept the project?
 What decision rule should be the primary decision-making method?
 Practice
PB Period
PAYBACK
PAYBACK
Y0 Y1 Y2 Y3 Y4 Y5
Cashflow (100,000) 25,000 25,000 25,000 25,000 25,000
Cumulative Inflows 25,000 50,000 75,000 100,000 125,000

NPV, IRR, PI
NPV, IRR, PI
Y0 Y1 Y2 Y3 Y4 Y5
Cashflow (100,000) 25,000 25,000 25,000 25,000 25,000
Discount Rate (r) 9%
PV Cashflows (100,000) 22,936 21,042 19,305 17,711 16,248
=25000 =25000 =25000 =25000 =25000
(1+r)1 (1+r)2 (1+r)3 (1+r)4 (1+r)5
Σ PV(Outflow) = 100,000
Σ PV(Inflow) = 97,241
NPV = - 2759
PI = 0.97
IRR = 7.93% (Through Iterations)
Class Exercise
Consider the following three cash flow profiles:
Year ending
0 1 2 3 4 5
Project 1 -100 20 20 20 20 120
Project 2 -100 33.44 33.44 33.44 33.44 33.44
Project 3 -100 85.22 85.22 85.22 85.22 -300

Assume Required Return = 12%

Calculate IRR, NPV, and Payback periods for the projects
Which ones should we take?
Real Life Applications
Mutually Exclusive Projects
Capital Rationing
Side Effects
Managerial Options / Real Options
Mutually Exclusive Projects
Mutually exclusive projects
◦ If you choose one, you can’t choose the other
◦ Example: You can choose to attend graduate
school next year at either Harvard or Oxford,
but not both

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Case Study - Mutually Exclusive Projects
The required return Period Project A Project B
for both projects is 0 -500 -400
10%.
1 325 325

2 325 200
 Calculate NPV and IRR

 Which project should

you accept and why?
Case Study - Mutually Exclusive
Projects
NPV & IRR suggests Period Project A Project B
different here
0 -500 -400
◦ Which to choose?
1 325 325
◦ Why?
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74
Capital Rationing
A situation in which a constraint exists on
funds available such that not all positive
NPV projects will be accepted.
Requires need to ration available funds to
projects with maximum value addition to
firm
◦ Maximize the NPV Subject to Budget
◦ Require correct ranking of projects
◦ PI is most suitable in such scenario
Example : Capital Rationing
As
 the CFO of Super Corp., you have to decide which projects to
invest from the following ones. You have $600,000 to spend.
Which should you choose?
Project In. Invest. PV(CF)NPV
1. $300,000$336,000$36,000
2. $100,000$120,000$20,000
3. $100,000$108,000$ 8,000
4. $200,000$230,000$30,000
5. $200,000$190,000-$10,000
6. $300,000$330,000$30,000
Example : Capital Rationing
Project In. Invest. PV(CF) PI
NPV
1. $300,000 $336,000 1.12
$36,000
2. $100,000 $120,000 1.20
$20,000
3. $100,000 $108,000 1.08 $
8,000
4. $200,000 $230,000 1.15
$30,000
5. $200,000 $190,000 0.95 -
$10,000
6. $300,000 $330,000 1.10
$30,000

 Choose: Projects 1, 2, 4
Projects with Side Effects
Projects can also have side effects on the
firm or other projects
Examples
◦ A new product launching can reduce your
existing product sales
◦ Investing in new warehouse also reduces costs
of storage for existing plant productions
These side effects should also be
considered in decision making
Example : Project with Side Effects
Project investment size = 200,000
Cashflows: 75,000 per year for 10 years
New project will also reduce your
existing sales of product X by 20,000 per
year

NPV = ?
Real Options
Very often managers has several flexibilities in making investment
decisions, which are known as managerial options or real options
In these cases, application of financial options theory is applied to
real asset investments , hence the name real options

Example of real options :

◦ Delay investing in a project
◦ Choose the project’s initial capacity
◦ Expand capacity of the project subsequent to the original investment
◦ Change the project’s technology
◦ Shutdown the project with the intention of restarting it later
◦ Abandon or sell the project
◦ Extend the life of the project
◦ Invest in further projects contingent on investment in the initial project
Real Options
 NPV RULEFOR PROJECT ACCEPTANCE MUST
BE ADJUSTED IF OPTIONS ARE INVOLVED.
◦ NPV With Real Option = NPV of project + NPV of Option
◦ Decision Rule:
 NPV of project + NPV of Option > NPV of Project , Take the project
with Real option
 NPV of project + NPV of Option < NPV of Project, Take the projct
only
Real Option Example – Delaying a
Project
You have a project that requires a $20
million investment. You expect the
project to provide future cash flows
with present value of $22 million.
◦ The option to delay the project for two
years is worth $9.5 million,
Should you accept the project now or
wait?
Real Option – Delay a Project
NPV of project = 22-20 = 2 million

Time value of the option to delay = 9.5

- (22 - 20) = 7.5

Since NPV = (22 -20) = 2 < 7.5 then

wait.
Insights : Identifying Relevant Cash
Flows
 Project initiation:
◦ Required investment outlays, including installation costs
◦ Includes incremental net working capital commitments
 Project operation:
◦ Cash operating expenses, net of tax
◦ Additional net working capital requirements
◦ Operating cash inflows, net of tax
 Project disposal:
◦ Net of tax investment disposal
◦ Recapture of investment in net working capital
Our Golden Rules
(1) Cash flows are the concern.
(2) Consider only incremental cash flows.
(3) Don’t forget induced changes in NWC.
(4) Don’t ignore opportunity costs.
(5) Never, never, never neglect taxes.
(6) Don’t include financing costs in cash flow.
(7) Treat inflation consistently.
(8) Recognize project interactions.
Case Study – Replacement Decision
 Droppitt Parcel Company is considering purchasing new
equipment to replace existing equipment that has book value
of zero and market value of $15,000.
 New equipment costs $90,000 and is expected to provide
production savings and increased profits of $20,000 per year
for the next 10 years.
 New equipment has expected useful life of 10 years, after
which its estimated salvage value would be $10,000.
 Straight-line depreciation
 Effective tax rate: 34%
 Cost of capital: 12%
 “Machinery Replacement” Problem: Should Droppitt
replace current equipment?
Case Study
1. Effective cost of new equipment:
$80,100
◦ Droppits trades its old equipment in for new
equipment by selling it and applying sale
proceeds to new equipment.
 After Tax Sales Proceeds:15000*(1-34%) =
9900
 New Equipment Cost = 90000
 Effective Cost = 90000-9900 = 80100
Case Study
2. Calculate present value of expected
benefits of new equipment.
◦ All benefits have been converted to after-tax basis before
present values are calculated.
◦ Profit increase is multiplied by 0.66 (1.00 – tax rate) to
determine increased profit remaining after tax.
◦ Calculate tax benefit resulting from effect of depreciation by
multiplying annual depreciation deduction by effective tax
rate.
◦ Reflects salvage value of new equipment at end of its
expected useful life.
 No tax effect here because there is no profit or loss
involved.
Case Study
3. NPV: $13,068
4. IRR (solved by trial and error): 15.7%
 New machine should be purchased to
replace old machine since NPV is
positive and IRR exceeds cost of
capital.
DISCUSSIONS
Thank You