CHAPTER 8, BOOK T2

INVESTMENT CRITERIA CHAPTER 8 TEXTBOOK T2FINANCIAL FEASIBILITY OF PROJECTSESTIMATE THE COSTS AND BENEFITS OF THE PROJECTASSESS THE RISKINESS OF THE PROJECTCALCULATE THE COST OF CAPITALCOMPUTE THE CRITERIA OF MERIT JUDGE THE PROJECT IS GOOD OR BADCOST OF CAPITALIT IS THE WEIGHTED AVERAGE COST OF VARIOUS SOURCES OF FINANCE FOR THE FIRMEXAMPLE: COST OF EQUITY = 16% PROPORTION = 50%COST OF PREFERENCE = 12% PROPORTION= 40%COST OF DEBT = 8% PROPORTION = 10%COST OF CAPITAL = (16X0.5) + (12X0.4) + (8X0.1)=12.4%SELECTION CRITERIAFINANCIAL MODELS: PREFERRED METHOD TO EVALUATE PROJECTSPAY BACK PERIOD (in years) : ESTIMATED PROJECT COSTS / ANNUAL SAVINGS RETURN ON INVESTMENT (in %)NET PRESENT VALUE (NPV) : uses time value of money, cash flows and profitabilityNON-FINANCIAL CRITERIA: STRATEGIC, LESS TANGIBLE, RESTORE CORPORATE IMAGE, ENHANCE BRAND RECOGNITIONMULTI-CRITERIA SELECTION MODELSCHECKLIST MODEL: LIST OF QUESTIONS TO REVIEW POTENTIAL PROJECTSDETERMINE ACCEPTANCE OR REJECTION

FLEXIBILITY IN SELECTING DIFFERENT PROJECTS WITH SOME VARIATIONS IN QUESTIONSFAILS TO ANSWER THE RELATIVE IMPORTANCE OR VALUE OF POTENTIAL PROJECTFAILS TO ALLOW COMPARISON WITH OTHER POTENTIAL PROJECTSROOM FOR POWER PLAY, POLITICS, MANIPULATIONMULTI WEIGHTED SCORING MODELSQUALITATIVE OR QUANTITATIVE CRITERIAEACH SELECTION CRITERIA IS ASSIGNED A WEIGHTSCORES ARE ASSIGNED TO EACH CRITERION FOR THE PROJECT BASED ON ITS IMPORTANCEWEIGHTS AND SCORES ARE MULTIPLIED TO GET TOTAL WEIGHTED SCORE FOR THE PROJECTPROJECTS WITH HIGHER SCORES ARE CONSIDERED BETTEREXAMPLECRITERION WEIGHTAGEA. STAY WITH CORE COMPETENCIES 2.0B. STRATEGIC FIT 3.0C. URGENCY 2.0D. 25% OF SALES FROM NEW PRODUCTS 2.5E. REDUCE DEFECTS TO LESS THAN 1% 1.0F. IMPROVE CUSTOMER LOYALTY 1.0G. ROI OF 18% + 3.0

CONTRIBUTION VALUES TO EACH CRITERION FOR EACH PROJECTPROJECT A B C D E F G WT. TOTAL1 1 8 2 6 0 6 5 662 3 3 2 0 0 5 1 273 3 0 10 0 0 6 0 324 1 10 5 10 0 8 9 102

HIGHEST PRIORITY : PROJECT 4, THEN PROJECT 1PROJECT SCREENED OUT : PROJECT 2 AND 3, IF CRITERION IS WEIGHTED TOTAL SHOULD BE MORE THAN 50APPLYING A SELECTION MODELPROJECT CLASSIFICATION: PROJECTS FIT TO ORGANIZATIONS STRATEGYSELECTING A MODEL: MULTIPLE CRITERIA TO SELECT THE PROJECTBEST USE OF HUMAN AND CAPITAL RESOURCES TO MAXIMIZE RETURN ON INVESTMENT IN THE LONG RUNRESEARCHING NEW TECHNOLOGIES, PUBLIC IMAGE, ETHICAL POSITION, PROTECTION OF ENVIRONMENT, CORE COMPETENCIES, STATEGIC FITCATEGORIES OF INVESTMENT CRITERIADISCOUNTING CRITERIANET PRESENT VALUE (NPV)BENEFIT COST RATIO (BCR)INTERNAL RATE OF RETURN (IRR)NON-DISCOUNTING CRITERIAPAYBACK PERIODACCOUNTING RATE OF RETURNNET PRESENT VALUE (NPV)NPV IS THE SUM OF THE PRESENT VALUES OF ALL THE CASH FLOWS: POSITIVE AS WELL AS NEGATIVE THAT ARE EXPECTED TO OCCUR OVER THE LIFE OF THE PROJECTNPV = Ct / (1 + r ) n - Investmentfor the period t=1 to t=nwhere Ct = cash flow at the end of year t n = life of the project r = discount rate IT IS THE NET BENEFIT OVER AND ABOVE THE COMPENSATION FOR TIME AND RISKACCEPT THE PROJECT IF NPV IS POSITIVEREJECT THE PROJECT IF NPV IS NEGATIVEPROPERTIESVALUE OF FIRM = PRESENT VALUE OF PROJECTS + NET PRESENT VALUE OF PROSPECTIVE PROJECTS WHEN A FIRM TERMINATES AN EXISTING PROJECT WHICH HAS NEGATIVE NPV BASED ON ITS EXPECTED FUTURE CASH FLOWS, THE VALUE OF FIRM INCREASES BY THAT AMOUNT

WHEN A FIRM DIVESTS ITSELF OF AN EXISTING PROJECT AND THE PRICE IS GREATER/LESSER THAN THE PRESENT VALUE OF THE ANTICIPATED CASH FLOWS OF THE PROJECT, THE VALUE OF FIRM WILL INCREASE/DECREASE WITH THE DIVESTITURE

WHEN A FIRM TAKES ON A NEW PROJECT WITH POSITIVE NPV, THE VALUE OF FIRM MAY DROP IF NPV IS NOT IN LINE WITH THE HIGH EXPECTATION OF INVESTORS

WHEN A FIRM MAKES AN ACQUISITION AND PAYS A PRICE IN EXCESS OF THE PRESENT VALUE OF THE EXPECTED CASH FLOWS FROM THE ACQUISTION IT IS TAKING ON A NEGATIVE NPV PROJECT AND HENCE WILL DIMINISH THE VALUE OF THE FIRM INTERMEDIATE CASH FLOWS ARE INVESTED AT COST OF CAPITALCASH FLOWS THAT OCCUR BETWEEN THE INITIATION AND THE TERMINATION OF THE PROJECT ARE INVESTED AT A RATE OF RETURN EQUAL TO THE COST OF CAPITALNPV CALCULATIONS PERMITS TIME VARYING DISCOUNT RATESNPV = Ct / (1 + ri)n - Initial InvestmentNPV OF A SIMPLE PROJECT STEADILY DECREASES AS THE DISCOUNT RATE INCREASES

EXAMPLE 1YEAR CASH FLOW 0(1,000,000) 1 200,000 2 200,000 3 300,000 4 300,000 5 350,000COST OF CAPITAL = r = 10% NPV = - 1,000,000 + 200,000 + 200,000 + (1.10)0 (1.1)1 (1.1)2

300,000 + 300,000 + 3, 50,000 (1.1)3 (1.1)4 (1.1) 5

= - Rs. 5272EXAMPLE 2YEAR CASH FLOW DISCOUNT RATE 0 (12000) 1 4000 14% 2 5000 15% 3 7000 16% 4 6000 18% 5 5000 20%SOLUTIONNPV = -12000 + 4000 + 5000______ + (1.14) (1.14)(1.15) 7000___________ + 6000________________ +(1.14)(1.15)(1.16) (1.14)(1.15)(1.16)(1.18)

5000________________ = 5592(1.14)(1.15)(1.16)(1.18)(1.20)MODIFIED NET PRESENT VALUECALCULATE THE TERMINAL VALUE OF THE PROJECTS CASH INFLOWS USING REINVESTMENT RATE THAT REFLECTS PROFITABILITY OF INVESTMENT

TV = CFi (1 + r)n-tWhere TV is the terminal value of the projects cash inflows, CFi is the cash inflow at the end of year t and r is the reinvestment rateNPV = TV / (1 + r)n - Investment Outlay

Project X Project YInvestment Outlay 110,000 110,000 Year 1 31,000 71,000 Year 2 40,000 40,000 Year 3 50,000 40,000 Year 4 70,000 20,000Re-investment rate = 14% and 20%

Project X(TV) 14% = 224,911 NPV = 43,614(TV) 20% = 241,168 NPV = 54,717

Project Y(TV) 14% = 222, 774 NPV = 42,158(TV) 20% = 248, 288 NPV = 59,584BENEFIT COST RATIOBENEFIT COST RATIO (BCR) = (PVB) / IPVB = PRESENT VALUE OF BENEFITSI = INITIAL INVESTMENT

NET BENEFIT COST RATIO (NBCR) = BCR 1BCR NBCR RULE> 1 > 0 ACCEPT= 1 = 0 INDIFFERENT< 1 < 0 REJECT EXAMPLE 3INITIAL INVESTMENT (I) : 100,000YEAR 1 25000YEAR 2 40000YEAR 3 40000YEAR 4 50000BCR = PVB / I r = 12%BCR = 1.145 NBCR = 0.145INTERNAL RATE OF RETURN (IRR)IRR IS THE DISCOUNT RATE WHICH MAKES NPV EQUAL TO ZERO

INVESTMENT = Ct / (1 + r)t for t = 1 to t = n

ACCEPT : IF THE IRR IS GREATER THAN THE COST OF CAPITALREJECT : IF THE IRR IS LESS THAN THE COST OF CAPITAL EXAMPLE 4YEAR CASH FLOW 0(100,000) 1 30,000 2 30,000 3 40,000 4 45,000

1,00,000 = 30000/(1+r) + 30000 / (1+r)2 + 40000/(1+r)3 + 45000/(1+r)4Find r using trial and error method.Determine the net present value of the two closest rates of returnFind the sum of absolute values of the net present valueCalculate the ratio of net positive value of the smaller discount rate to the sum of absolute valuesAdd the number obtained above to the smaller discount rater = 15% NPV = 802r= 16% NPV = -1359Sum of absolute values = 2161Ratio = 802 / 2161 = 0.37IRR = 15 + 0.37 = 15.37%If cost of capital is say 10%, then accept the project

MODIFIED INTERNAL RATE OF RETURN (MIRR)CALCULATE THE PRESENT VALUE OF THE COSTS (PVC) USING THE COST OF CAPITAL AS THE DISCOUNT RATE PVC = CASH OUTFLOW / (1+r)tCALCULATE THE TERMINAL VALUE OF THE CASH INFLOWS EXPECTED FROM THE PROJECTTV = CASH INFLOW (1 + r)n-t PVC = TV / (1+MIRR)n

EXAMPLE 5YEAR CASH FLOW 0 - 120 1 - 80 2 20 3 60 4 80 5 100 6 120Cost of Capital = 15%SolutionPVC = 120 + 80/(1.15) = 189.6

TV = 20(1.5)4 + 60 (1.15)3+ 80 (1.15)2 + 100 (1.15) + 120 = 467

189.6 = 467 / (1 + MIRR)6 MIRR = 16.2%PAYBACK PERIODLENGTH OF TIME REQUIRED TO RECOVER THE INITIAL CASH OUTLAY ON THE PROJECTSHORTER THE PAYBACK PERIOD, MORE DESIRABLE IS THE PROJECT

ADVANTAGESIT IS SIMPLE BOTH IN CONCEPT AND APPLICATIONIT FAVORS PROJECTS WHICH GENERATE SUBSTANTIAL CASH INFLOWS IN EARLIER YEARS AND DISCRIMINATES AGAINST PROJECTS WHICH BRINGS CASH INFLOWS IN LATER YEARSIT IS USEFUL WHEN COMPANY IS PRESSED WITH PROBLEMS OF LIQUIDITYLIMITATIONSIT FAILS TO CONSIDER THE TIME VALUE OF MONEYIT IGNORES CASH FLOWS BEYOND THE PAYBACK PERIODIT IS A MEASURE OF PROJECTS CAPITAL RECOVERY, NOT PROFITABILITYIT MEASURES A PROJECTS LIQUIDITY BUT DOES NOT INDICATE LIQUIDITY POSITION OF THE FIRM AS A WHOLE DISCOUNTED PAYBACK PERIODIT TAKES INTO ACCOUNT TIME VALUE OF MONEYCASH FLOWS ARE CONVERTED TO THEIR PRESENT VALUES BY APPLYING DISCOUNTING FACTORSFIND THE CUMULATIVE NET CASH FLOW AFTER DISCOUNTING TILL WE GET POSITIVE VALUETHE CORRESPONDING PERIOD SHOWS THE DISCOUNTED PAYBACK PERIODEXAMPLE 6YEAR CASH FLOW PRESENT VALUE CUM. 0 -10000 -10000 -10000 1 3000 2727 -7273 2 3000 2478 -4795 3 4000 3004 -1791 4 4000 2732 941 5 5000 3105 6 2000 1130 Assuming r = 10% Discounted Payback Period = Between 3 and 4 years, say around 3.5 yearsACCOUNTING RATE OF RETURNIT IS THE AVERAGE RATE OF RETURN ON INVESTMENT AND IS A MEASURE OF PROFITABILITYAVERAGE INCOME AFTER TAX / INITIAL INVESTMENTAVERAGE INCOME AFTER TAX / AVERAGE INVESTMENTAVERAGE INCOME AFTER TAX BUT BEFORE INTEREST / INITIAL INVESTMENTAVERAGE INCOME AFTER TAX BEFORE INTEREST / AVERAGE INVESTMENTAVERAGE INCOME BEFORE INTEREST AND TAX / INITIAL INVESTMENTAVERAGE INCOME BEFORE INTEREST AND TAX / AVERAGE INVESTMENT(TOTAL INCOME AFTER TAX BUT BEFORE DEPRECIATION INITIAL INVESTMENT) / (INITIAL INVESTMENT/2 * YEAR)HIGHER THE ACCOUNTING RATE OF RETURN, THE BETTER THE PROJECTPROBLEM 1 / PAGE 8.29YEAR CASH FLOW 0- 1000,000 1 100,000 2 200,000 3 300,000 4 600,000 5 300,000Part A : Taking r = 14%Part B : Taking r=12% and then 1% increase every year PART A NPV = -1000000 + 100000/(1.14) + 200000/(1.14)2 + 300000/(1.14)3 + 600000/(1.14)4 + 300000/(1.14)5 = - Rs. 44837PART BNPV = -1000000 + 100000/(1.12) + 200000/(1.12)(1.13) + 300000/(1.12)(1.13)(1.14) + 600000/(1.12)(1.13)(1.14)(1.15) + 300000/(1.12)(1.13)(1.14)(1.15)(1.16) = - Rs. 27265PROBLEM 2, PAGE 8.29CURRENT OUTLAY = 300000ANNUAL CASH FLOW OF Rs. 60000 FOR 7 YEARS

300000 = 60000/(1+r) + 60000/(1+r)2 + 60000/(1+r)3 + 60000/(1+r)4 + 60000/(1+r)5 + 60000/(1+r)6 + 60000/(1+r)7

Trial and Error MethodTake r = 10 292105 -7895 r = 9 304165 4165Sum of absolute values = 12060Ratio = 4165/12060 = 0.345 IRR = 9 + 0.345 = 9.345