Lecture 24.02.2016

Investment
& Financing Decisions by the Financial Manger
Andreas Bange Diplom Betriebswirt (FH)
Investment Decision Rules
+++ MCO 201 +++ Finance +++ Spring 2016 +++
Investment & Financing Decisions by the Financial Manger
Decision Rules
The most popular Decision Rules used by CFOs
The NPV Decision Rules
NPV = PV (Benefits) PV (Costs)

Logic of the NPV Decision Rule:
When making an Investment Decision, take the alternative with
the highest NPV, which is equivalent to receiving its NPV in cash
today.
Example:
In exchange for $500 today, your firm will receive $550
in one year.
The interest rate is 8% per year:
Many companies measure Values in Terms of Net Present

Value.
In exchange for $500 today, your firm will receive $550 in one
year. If the interest rate is 8% per year:
PV (Benefit)
= ($550 in one year) ($1.08 $ in one year/$ today) = $509.26 today
This is the amount you would need to put in the bank today to generate
$550 in one year
NPV = $509.26 - $500 = $9.26 today
You should be able to borrow $509.26 and use the $550 in one year to repay the
loan.
This transaction leaves you with $509.26 - $500 = $9.26 today
As long as NPV is positive, the decision increases the value of the firm regardless of
current cash needs or preferences.
The NPV Decision Rule implies that we should:
Accept positive-NPV projects, because accepting them is equivalent to
receiving their NPV in cash today, and
Reject negative-NPV projects, because accepting them would
reduce the value of the firm, whereas rejecting them has no
cost (NPV = 0)
Problem:
After saving $1,500 waiting tables, you are about to buy a 42-inch plasma
TV. You notice that the store is offering one-year same as cash deal. You
can take the TV home today and pay nothing until one year from now, when you
will owe the store the $1,500 purchase price. If your savings account earns 5% per
year, what is the NPV of this offer? Show that its NPV represents cash in your
pocket.
Solution Plan:
You are getting something (the TV) worth $1,500 today and in exchange will need to
pay $1,500 in one year.
Think of it as getting back the $1,500 you thought you would have to spend today
to get the TV. We treat it as a positive cash flow.
Cash flows:
Today
$ 1,500
In one year
$ 1,500
The Discount Rate for calculating the Present Value of the payment in one year is
your interest rate of 5%. You need to compare the present value of the cost
($1,500 in one year) to the benefit today (a $1,500 TV).
The NPV is Equivalent to Cash Today

1,500
NPV = +1,500
= 1,500 1, 428.57 = $71.43
(1.05)
You could take $1,428.57 of the $1,500 you had saved for the TV and put it in your
savings account. With interest, in one year it would grow to $1,428.57 (1.05) =
$1,500, enough to pay the store. The extra $71.43 is money in your pocket to spend
as you like (or put toward the speaker system for your new media room).
Evaluate:
By taking the delayed payment offer, we have extra net cash flows of $71.43 today.
If we put $1,428.57 in the bank, it will be just enough to offset our $1,500
obligation in the future.
Therefore, this offer is equivalent to receiving $71.43 today, without any future net
obligations.
Execute:
Problem:
After saving $2,500 waiting tables, you are about to buy a 50-inch LCD TV.
You notice that the store is offering one-year same as cash deal. You can take the
TV home today and pay nothing until one year from now, when you will owe the
store the $2,500 purchase price. If your savings account earns 4% per year, what is
the NPV of this offer? Show that its NPV represents cash in your pocket.
Solution Plan:
You are getting something (the TV) worth $2,500 today and in exchange will need to
pay $2,500 in one year. Think of it as getting back the $2,500 you thought you
would have to spend today to get the TV. We treat it as a positive cash flow.
Cash flows:
Today In one year

$ 2,500 $ 2,500
The discount rate for calculating the present value of the payment in one year is
your interest rate of 4%. You need to compare the present value of the cost ($2,500
in one year) to the benefit today (a $2,500 TV).

$1,500
NPV = +$2,500
= $2,500 $2,403.85 = $96.15
1.04
You could take $2,403.85 of the $2,500 you had saved for the TV and put it in your
savings account. With interest, in one year it would grow to $2,403.85 (1.04) =
$2,500, enough to pay the store. The extra $96.15 is money in your pocket to spend
as you like.
Evaluate:
By taking the delayed payment offer, we have extra net cash flows of $96.15 today.
If we put $2,403.85 in the bank, it will be just enough to offset our $2,500
obligation in the future. Therefore, this offer is equivalent to receiving $96.15 today,
without any future net obligations.
Execute:
A take-it-or-leave-it decision:
Fredericks, a fertilizer company can create a new environmentally
friendly fertilizer at a large savings over the companys existing fertilizer.
The fertilizer will require a new factory that can be built at a cost of $81.6
million. Estimated return on the new fertilizer will be $28 million after the
first year, and last four years.
Computing NPV
The following timeline shows the estimated return:
Using the NPV Rule
Using the NPV Rule
NPV = 81.6 +
28
28
28
28
+
+
+
1 + r (1 + r ) 2 (1 + r )3 (1 + r ) 4
We can also use the annuity formula:
28
1
NPV = 81.6 + 1
4
r
(1 + r )
If the companys Cost of Capital is 10%, the NPV is $7.2 million and they should
undertake the investment.
Given a discount rate r, the NPV is:
NPV of Fredricks project

The NPV depends on Cost of Capital
NPV profile graphs the NPV over a range of discount rates
Based on this data the NPV is positive only when the discount rates are less
than 14%
NPV of Fredericks New Project
Using the NPV Rule
Alternative Decision Rules
Calculate the amount of time it takes to pay back the initial

investment, called the payback period.
Accept if the payback period is less than required.
Reject if the payback period is greater than required.
The Payback Rule

is based on the notion that an opportunity, that pays back
the initial investment quickly is the best idea.
Using the Payback Rule
Solution Plan:
In order to implement the payback rule, we need to know whether the sum of the
inflows from the project will exceed the initial investment before the end of 2 years.
The project has inflows of $28 million per year and an initial investment of $81.6
million.
Execute:
The sum of the cash flows from year 1 to year 2 is $28m x 2 = $56 million, this will
not cover the initial investment of $81.6 million. Because the payback is > 2 years
(3 years required $28 x 3 = $84 million) the project will be rejected.
Evaluate:
While simple to compute, the payback rule requires us to use an arbitrary cutoff
period in summing the cash flows. Also note that the payback rule does not discount
future cash flows. Instead it simply sums the cash flows and compares
them to a cash outflow in the present. In this case, Fredricks would have
rejected a project that would have increased the value of the firm.
Problem:
Assume Fredericks requires all projects to have a payback period of two
years or less. Would the firm undertake the project under this rule?
Year
Expected Net Cash Flow
-$10,000
$1,000
$1,000
$12,000
Solution Plan:
The project has inflows of $1,000 for two years, an inflow of $12,000 in year three,
and an initial investment of $10,000.
Problem:
Assume a company requires all projects to have a payback period of three
years or less. For the project below, would the firm undertake the project under this
rule?
Evaluated:
period in summing the cash flows.
Further, also note that the payback rule does not discount future cash flows.
Instead it simply sums the cash flows and compares them to a cash outflow in the
present.
Execute:
The sum of the cash flows from years 1 through 3 is $14,000. This will
cover the initial investment of $10,000. Because the payback is less than 3 years the
project will be accepted.
Problem:
Assume a company requires all projects to have a payback period of three
years or less. For the project below, would the firm undertake the project under this
rule?
Year Expected Net Cash Flow
0
-$10,000
$1,000
$1,000
$1,000
$1,000,000
Solution Plan:
The project has inflows of $1,000 for three years, an inflow of $1,000,000 in year
four, and an initial investment of $10,000.
Execute:
The sum of the cash flows from years 1 through 3 is $3,000.
This will not cover the initial investment of $10,000.
Because the payback is more than 3 years the project will not be accepted, even
though the 4th cash flow is very high!
Evaluated:
Further, also note that the payback rule does not discount future cash flows in this
case, a huge mistake!
Instead it simply sums the cash flows and compares them to a cash outflow in the
present.
Problem:
When choosing between two projects, assume a company chooses the one
with the lowest payback period. Which of the following two projects would the firm
undertake the project under this rule?
Project A
Project B
Year
Expected Net
Expected Net
Cash Flow
Cash Flow
-$10,000
-$10,000
$1,000
$5,000
$1,000
$5,000
$8,000
$5,000
$1,000,000
$5,000
Solution Plan:
In order to implement the payback rule, we need to know when the sum of the inflows
from the project will equal the initial investment.
Project A has inflows of $1,000 for two years, an inflow of $8,000 in year 3,
and an inflow of $1,000,000 in year four. Initial investment is $10,000.
Project B has inflows of $5,000 for four years with an initial investment of
$10,000.
Execute:
For Project A:
The sum of the cash flows from years 1 - 3 is $10,000.
This will cover the initial investment of $10,000 at the end of year 3.
For Project B:
The sum of the cash flows from years 1 and 2 is $10,000.
This will cover the initial investment of $10,000 at the end of year 2.
Because the payback for Project B is faster than for Project A, Project B will be
chosen, even though the 4th cash flow for Project A is very high!
Evaluate:
Further, also note that the payback rule does not discount future cash flows in this
case, a huge mistake!
Instead it simply sums the cash flows and compares them to a cash
outflow in the present.
Weakness of the Payback Rule

Ignores the time value of money
Ignores cash-flows after the payback period
Lacks a decision criterion grounded in economics
Fredericks Fertilizer Company
Weakness in IRR
In most cases IRR rule agrees with NPV for stand- alone
projects if all negative cash flows precede positive cash
flows.
In other cases the IRR may disagree with NPV.
The Internal Rate of Return (IRR) Rule

Take any investment opportunity where IRR exceeds the
opportunity Cost of Capital.
The Delayed Investments

Two competing endorsements:
Offer A: single payment of $1million upfront
Offer B: $500,000 per year at the end of the next three years
Estimated cost of capital is 10%
Opportunity timeline:

The NPV is:
Set NPV to zero and solve for r to get IRR.
Given:
Solve for:
1,000,000
-500,000
23.38
Excel Formula: =RATE(NPER,PMT,PV,FV)

= RATE(3,-500000,1000000,0)
500,000 500, 000 500, 000

NPV = 1, 000,000
2
3
1+ r
(1 + r )
(1 + r)
500,000 500, 000 500, 000

NPV = 1, 000,000
= $243,426
2
3
1.1
1.1
1.1
However, NPV shows Option B best.

To resolve the conflict we can show a NPV Profile
23.38% > the 10% opportunity cost of capital, so according to IRR,
Option A best.
Given:
Solve for:
1,000,000
-500,000
23.38
Excel Formula: =RATE(NPER,PMT,PV,FV)

= RATE(3,-500000,1000000,0)
The NPV is:
For most investments expenses are upfront and cash is

received in the future. In these Cases a low rate is best.
When cash is upfront a high interest rate is best.
The Bottom Line on IRR

Picking the investment opportunity with the largest IRR
can lead to a mistake
In general, it is dangerous to use the IRR in choosing between
projects
Always rely on NPV
Choosing between Projects
Evaluating Projects with Different Lives
Evaluating Projects with Different Lives
TABLE 1.1
Cash Flows ($ Thousands) for Network Server Options
TABLE 1.2
Cash Flows ($ Thousands) for Network Server Options,
expressed as Equivalent Annual Annuities
Often, a company will need to choose between two or more

solutions to the same problem.
Computing an Equivalent Annual Annuity
Solution:
In order to compare this new option to Server A, we need to put it an equal footing
by computing its annual cost. We can do this
1. Computing its NPV at the 10% discount rate we used above
2. Computing the equivalent 4-year annuity with the same present value.
Problem:
You are about to sign the contract for Server A from Table 1.1 when a third
vendor approaches you with another option that lasts for 4 years. The cash flows for
Server C are given below. Should you choose the new option or stick with Server A?

1
1
= 17.80
PV = 14 1.2
4
.10
.10 (1.10 )
PV
17.80
Cash Flow =
=
= 5.62
1
1
1
1
4
4
.10 .10 (1.10 ) .10 .10 (1.10 )
Its annual cost of 5.62 is greater than the annual cost of Server A (5.02), so we
should choose Server A.
Evaluate:
In this case, the additional cost associated with purchasing and maintaining Server C
is not worth the extra year we get from choosing it. By putting all of these costs into
an equivalent annuity, the EAA tool allows us to see that.
Execute:
Problem:
You considering a maintenance contract from two vendors. Vendor Y
charges $100,000 upfront and then $12,000 per year for the three-year life of the
contract. Vendor Z charges $85,000 upfront and then $35,000 per year for the twoyear life of the contract. Compute the NPV and EAA for each vendor assuming an
8% cost of capital.
0
-$100,000
0
-$12,000
1
-$12,000
2
-$12,000
-$35,000
-$35,000
Vendor Y
Vendor Z
-$75,000
Solution:
In order to compare the two options, we need to put both on an equal footing by
computing its annual cost. We can do this
1. Computing its NPV at the 8% discount rate we used above
2. Computing the equivalent annual annuity with the same PV
Execute:
1
PVY = $100,000 $12,000
= $130,925
3
.
08
.
08
(
1
.
08
)
PVY
$130,925
Cash Flow Y =
=
= $50,803
1
1
1
1
.08 .08(1.08) 3 .08 .08(1.08) 3
1
PVZ = $75,000 $35,000
= $137,414
2
.
08
.
08
(
1
.
08
)
PVZ
$137,414
Cash Flow Z =
=
= $77,058
1
1
1
1
.08 .08(1.08) 2 .08 .08(1.08) 2
The annual cost of Vendor Z is greater than the annual cost of Vendor Y, so we
should choose Vendor Y.
Evaluate:
In this case, the higher upfront cost associated with Vendor Y is worth the
extra year we get from choosing it. By putting all of these costs into an
equivalent annuity, the EAA tool allows us to see that.
Choosing among Projects when Recourses are Limited
Sometimes different investment opportunities demand

different amounts of a particular resource.
If there is a fixed supply of the resource so that you cannot undertake
all possible opportunities, simply picking the highest-NPV opportunity
might not lead to the best decision.
Possible Projects for $200 Million Budget
=
=

Choosing among Projects when Recourses are Limited
Problem:
Your division at NetIt, a large networking company, has put together a project
proposal to develop a new home networking router. The expected NPV of the
project is $18.8 million, and the project will require 50 software engineers.
NetIt has a total of 190 engineers available, and is unable to hire additional qualified
engineers in the short run. Therefore, the router project must compete with the
following other projects for these engineers:
Project
NPV ($ Millions)
Engineering Headcount
Router
18,8
50
Project A
22,7
47
Project B
8,1
44
Project C
14,0
40
Project D
11,5
61
Project E
20,6
58
Project F
Total
12,9
108,6
32
332
How should NetIt prioritize these projects?

Profitability Index with Human Resource Constraint
Project
Router
Project A
Project B
Project C
Project D
Project E
Project F
Total
NPV ($ Millions)
18,8
22,7
8,1
14,0
11,5
20,6
12,9
107,5
50
47
44
40
61
58
32
332
PI
0,38
0,48
0,18
0,35
0,19
0,36
0,40
We now assign the resource to the projects in descending order according

to the profitability index.
Solution:
The goal is to maximize the total NPV we can create with 190 employees (at most).
Use the profitability index equation for each project. In this case, since engineers are
our limited resource, we will use Engineering Headcount in the denominator. Once
we have the profitability index for each project, we can sort them based on the index.
Execute:
Execute:
Project
Project A
Project F
Router
Project E
Project C
Project D
Project B
NPV ($ Millions)
22,7
12,9
18,8
20,6
14,0
11,5
8,1
47
32
50
58
40
61
44
PI
0,48
0,40
0,38
0,36
0,35
0,19
0,18
Cumulative Engineering
Headcount
47
79
50
108
148
209
253
By ranking projects in terms of their NPV per engineer, we find the most value we
can create, given our 190 engineers.
There is no other combination of projects that will create more value without using
more engineers than we have.
This ranking also shows us exactly what the engineering constraint costs
usthis resource constraint forces NetIt to forgo two otherwise valuable
projects (D, and B) with a total NPV of $19.6 million.
Solution:
The final column shows the cumulative use of the resource as each project
is taken on until the resource is used up.
Execute:
Project
Project A
Project F
Router
Project E
Project C
Project D
Project B
NPV ($ Millions)
22,7
12,9
18,8
20,6
14,0
11,5
8,1
47
32
50
58
40
61
44
PI
0,48
0,40
0,38
0,36
0,35
0,19
0,18
Cumulative Engineering
Headcount
47
79
129
187
227
288
332
By ranking projects in terms of their NPV per engineer, we find the most value we
can create, given our 190 engineers.
more engineers than we have.
This ranking also shows us exactly what the engineering constraint costs
usthis resource constraint forces NetIt to forgo three otherwise valuable
projects (C, D, and B) with a total NPV of $33.6 million.
Solution:
Problem:
AaronCo is considering several projects to undertake. All of the projects currently
under consideration have a positive NPV, but AaronCo has a fixed capital budget of
$300 million. The company does not believe they will be able to raise any additional
funds. How should AaronCo prioritize the projects?
Project
A
B
C
D
E
F
G
Total
NPV ($ Millions)
$15
$25
$110
$60
$25
$20
$35
$290
Initial Cost ($ Millions)

$25
$75
$200
$150
$50
$35
$40
$575
Execute:
Project
A
B
C
D
E
F
G
Total
NPV ($ Millions)
$15
$25
$110
$60
$25
$20
$35
$290

$25
$75
$200
$150
$50
$35
$40
$575
We now assign the resource to the projects in descending order according

to the profitability index.
PI
0,60
0,33
0,55
0,40
0,50
0,57
0,88
Solution:
The goal is to maximize the total NPV we can create with $300 million (at most).
In this case, since money is our limited resource, we will use Initial Cost in the
denominator. Once we have the profitability index for each project, we can sort them
based on the index.
Execute:
Project
G
A
F
C
E
D
B
NPV ($ Millions)
$35
$15
$20
$110
$25
$60
$25

$40
$25
$35
$200
$50
$150
$75
PI
0,88
0,60
0,57
0,55
0,50
0,40
0,33
Cumulative Initial Cost ($

Millions)
$40
$65
$100
$300
$350
$500
$575
By ranking projects in terms of their NPV per initial cost, we find the most value we
can create, given our $300 million budget.
more money than we have.
This ranking also shows us exactly what the budget constraint costs us
this resource constraint forces AaronCo to forgo three otherwise valuable
projects (B, D, and E) with a total NPV of $110 million.
Solution:
Putting it Together
Putting it Together

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