Module 10 – Capital Investment Decisions

Page 595
Review questions
Question 2
Figures 18.1 identifies seven steps for making an investment decision. Noting the investment decision
occupies Step 5, discuss the importance of Steps 1 to 4 to the successful implementation of a preferred
project.
1. Gap analysis
2. Conceptual scoping study
3. Pre-feasibility study
4. Feasibility study
5. Investment decision
6. Investment implementation
7. Post-investment evaluation

Many capital expenditure decisions entail the acquisition of new technologies and systems that
enable the firm to reduce costs, reduce the investment in working capital, improve production
efficiency and/or capacity and/or enhance product or service quality. In other words, the firm
wants to do something better than it has previously done. However, before making the
investment decision at step 5 in Figure 18.1, there are four steps that precede it. These are
as follows: 1 Gap analysis: the need for investment, 2 Conceptual scoping study, 3 Pre-
feasibility study and 4 Feasibility study.
Gap analysis identifies that the firm has a performance issue requiring resolution. Having
identified that performance gap exists, the conceptual scoping study documents the nature
and extent of the gap for the purpose of informing subsequent steps. The pre-feasibility
study provides a preliminary examination of the performance gap and identifies and
evaluates feasible options for closing the gap. Finally, the feasibility study takes into
account all of the preferred option’s factors, including those relating to economic,
technical, legal, and project scheduling considerations. Thus, the feasibility study
determines whether or not the preferred option will successfully close the performance
gap. The making of a capital investment decision (i.e. step 5) cannot be done lacking
knowledge of the existence and nature of the problem to be resolved and the feasibility of
alternative and preferred options. In other words, the carrying out of these four preceding
steps ensures that a manager has the best quality data available to inform their capital
investment decision and will be able to avoid the scenario of ‘garbage-in, garbage-out’.

Question 6
NPV and IRR are two DCF methods for analysing a proposed capital investment decision and the strengths
and weaknesses of each.

Discounted cash flow methods recognise the time value of money concept with the net present
value (NPV) and internal rate of return (IRR) being the two most commonly used approaches
for analysing a proposed capital investment. Both approaches are based on the time value of
money concept where the value of a dollar to be received (or paid) in the future is less than the
value of a dollar received (or paid) today.
Net present value method
 A proposed investment’s NPV is the present value of net cash inflows generated by the
investment, including salvage value, if any, less the initial cost of the investment. Using a
defined target rate of return (e.g. the firm’s weighted average cost of capital or WACC), the
present value of future net cash inflows are calculated, summed and offset against the cost
of the investment. For most proposed capital investments, where a positive NPV is
determined it could be accepted. In some cases, where an investment might be required (e.g.
investments in pollution abatement plant and equipment), the investment with the lowest
negative NPV (or net present cost) could be recommended.
The IRR is the rate of return a proposed investment generates where it is the interest rate
that discounts future net cash inflows back to an aggregate present value equalling the cost
of the investment (i.e. the proposed investment has an NPV = 0).
Strengths of DCF analysis, NPV and IRR approaches
When proposed capital investments are being evaluated, a major strength of the DCF
method is the explicit consideration that is given to the time value of money concept.
Furthermore, unlike the payback method, both DCF methods consider whole of life net cash
inflows when making the investing decision. Finally, both DCF methods consider the
minimum return required on the funds invested in the business (i.e. the weighted average cost of
capital). A common weakness for both DCF methods is that they require a sound
understanding of corporate finance and an ability to use financial mathematics.
In terms of the specific weaknesses of the NPV method, it assumes that an investment will
pose the same level of risk throughout its duration. However, the level of risk can change
depending at the point at which the investment is situated in its life cycle. For example, the
risk for a proposed investment might be high early on and then become lower as the
investment matures. Whilst the use of different interest rates might be appropriate at
different stages of such a proposed investment’s life, this makes the NPV approach a more
complex method to use in practice. Furthermore, calculated net present values are highly
sensitive to the interest rate used. For example, if the interest rate used to determine present
values is set too high, otherwise acceptable investments might have a negative NPV and be
rejected. Similarly, if the interest rate is set too low, investment proposals with a calculated
positive NPV might be accepted when they ought to be rejected. Finally, with competing or
mutually exclusive investment proposals, the NPV method cannot address projects of
different size.
The major benefit of the IRR method is that it provides a metric that is easy to interpret (i.e.
if a proposed investment has an IRR of 15% and the firm has a cost of capital of 12%, then
it should be recommended as 15% IRR > 12% cost of capital). However, for some
investment proposals that have unusual patterns in future net cash inflows (e.g. changing
positive and negative signs in annual cash flows such as: +, + –, +, +, –), it is possible that
there is no single or unique IRR value. Furthermore, the assumption that the future net cash
inflows of a proposed investment can be invested to return the IRR may not be valid.
Finally, with mutually exclusive investment projects, the IRR may incorrectly rank
investment proposals to the extent that a project that ought to be recommended on NPV
grounds is rejected in favour of a higher IRR-rated project.

Question 7
‘When using DCF analysis to make an investment decision, many overheads, including depreciation, are
irrelevant.” Critically evaluate this statement and comment on the extent that overheads, including
depreciation, are relevant or irrelevant to an investment decision.
 As suggested by the term ‘DCF’, the approach refers to the analysis of future flows that are
measured in cash. As depreciation expense is a non-cash cost, it is initially irrelevant to the
analysis required when making an investment decision. However, if the depreciation expense
generates an allowable deduction for taxation purposes, it will be relevant to the extent of the tax
shield it provides. For example, if an allowable deduction for $100 0000 in depreciation expense is
claimed, a tax rate of 30 per cent will result in a positive cash inflow of $30 000 (i.e. the reduction in
taxes paid = $100 000 x 30%). Thus, whilst the depreciation expense associated with a proposed
investment itself is not relevant to the investment decision, the cash benefit of the tax shield it provides,
where applicable, will be.
For other overheads, as some may be fixed in the short term (e.g. accommodation or facility-related
costs), a proposed investment may not cause these costs to change. Hence, as only the differential or
incremental cash flows of a proposed investment are to be taken into account, they would be irrelevant.
However, if a proposed investment causes cash overhead costs to change (e.g. additional supervisory
salaries), these will be relevant to the investment decision.

Question 10
‘When it comes to making a capital investment decision, it is only the quantitative outcomes that really
matter.’ Critically evaluate that statement using a capital investment that you have some knowledge of to
illustrate your response.

In responding to this discussion question, the provision of a real capital investment project
was invited. If none are forthcoming, identify a major infrastructure project that is being
undertaken in your local area (e.g. a renewal of existing road or rail system). Invite a
discussion of what quantitative and qualitative factors are present in a project such as these
and how they are accounted for in the project evaluation stage. As an illustration of how a
discussion of this question might unfold, the case of the Western Sydney Infrastructure Plan
(WSIP) is provided.
Clearly those outcomes that can be quantified can carry greater importance in the making of
a capital investment decision. For example, a capital investment decision typically entails
the consideration of five critical project factors: timeliness, cost, quality, scale and scope.
Each of these can be quantifiable in one form or another. Such quantitative measures of
outcomes are more readily understood and incorporated into the evaluation of a capital
investment project. However, a project can also have less than beneficial outcomes that are
not as readily measurable (e.g. impacts on the community and/or environment). As such
outcomes often take the form of a project externality (i.e. there is no transactional base used
to record their impact), they can be ignored or relegated to being a qualitative factor.
An illustrative case example: Western Sydney Infrastructure Plan (WSIP)
With the growth in population densities in the western suburbs of Sydney and the
construction of the Western Sydney International Airport (to open in 2026), the Australian
and New South Wales governments are jointly funding the $AUD4.1 billion Western
Sydney Infrastructure Plan (WSIP). The project is delivering significant road infrastructure
upgrades and, in providing an integrated transport solution for the Western Sydney region,
will generate economic benefits as a result of reducing road congestion and improving
travelling time for road users. Additionally, with more efficient traffic flows and improved
landscaping of road reserves and adjacent land holdings, it is expected that WSIP will make
Western Sydney a better and safer place to live and do business.
In terms of the five critical project factors for WSIP, note:
Timeliness
Two dimensions for time are present for WSIP: the time it will take to complete WSIP and
the reduced travel times that will result from the completed plan delivering more efficient
traffic flows. In the case of project completion, given that the WSIP is such a large road
infrastructure project, it is unsurprising that this is a multi-year project that had started prior
to 2015 and will reach full completion until after 2025. In terms of reduced travel times for
road users, estimates vary as to how much time will be saved and actual savings will be
affected by the time of day travel is undertaken. For example, estimates of gains resulting
from the WestConnex part of WSIP range from 1.7 per cent to an upper estimate of 3 per
cent.
Cost

As noted, the total cost of WSIP project is estimated to be $AUD4.1 billion with forecast
peak expenditure in excess of $550 million expected to be incurred during the 2019-20
financial year.
Quality
Apart from the quality of the design of the road infrastructure itself and quality of materials
used in its construction (e.g., including properties such as the structural condition and
smoothness of ride provided by a road), the WSIP will also have less measurable aesthetics
in terms of urban lighting, landscaping and architectural landmarks including distinctive
artworks, bridges, intersections and vistas.
Scope
Scope refers to the capacity to be provided by WSIP. For example, WestConnex’s M4-M5
Link Tunnels, two 7.5-kilometre long tunnels, will provide the capacity to accommodate up
to four lanes of traffic moving in each direction. By providing four lanes of traffic, it means
that each tunnel will have greater vehicle movement capacity than if it only had three lanes.
Scale
Scale refers to the size of the WSIP and it will comprise some 62.6 kilometres of roads and
75 intersections. WSIP is being delivered through individual projects (e.g. construction of
the M4-M5 Link Tunnels).
Note how WSIP utilises a broad range of financial and non-financial attributes in
quantifying the plan’s outcomes ranging from measures of time, cost, quality, scope and
scale. Importantly, each of these measurable outcomes can be interrelated where a change in
one critical factor outcome has a trade-off effect on one or more other outcomes. For
example, where a road is designed to cope with a higher and heavier volume of traffic than
otherwise forecast, the costs and time taken to construct the road will increase. However,
whilst such negative impacts of constructing a better road surface will initially occur, this
will be offset by the reduction in future road maintenance costs and less efficient traffic
flow movements during future road repairs. Similarly, a decision to build a tunnel that
accommodates four lanes of traffic rather than three, will initially cost more and take longer
to construct. However, a four-lane tunnel will deliver improved traffic flow efficiency and a
lower cost solution for adding additional capacity (e.g. increasing lanes from three to four)
at a subsequent point in time.
By the very nature of SWIP, a project of such significance can have a detrimental impact on
stakeholders who are simply affected by virtue of their proximity to project sites. For
example, the construction and subsequent use of a major infrastructure project, such as
SWIP, will impact on air and water quality, noise levels and vibrations and environmental
 concerns such as threats to biodiversity. Whilst projects, such as SWIP, will draw upon a
wide range of structural features to incorporate within the project’s architecture (e.g.
drainage and noise dampening ‘walls’), not all environmental impacts will be mitigated.
Although a project’s outcomes might be well-documented in terms of quantifiable outcomes
and these do influence the assessment of project merit, a failure to consider qualitative
outcomes can thwart even the best of laid plans.

Problems Page 596

Problem 2
The Fidget Co. is proposing to spend $91 280 on a seven-year project whose estimated net cash flows are
$20000 for each of the seven years.
a. Calculate the net present value using a rate of 15% (use the table of present values in Appendix 2 –
or do a search online for present value table).
b. b. Based on the analysis prepared in (a), is the rate of return:
i more than 15%
ii 15%
iii less than 15%
c. Briefly explain your response.
The Fidget Company
a Using the discount factor of 4.1604 for the present value of an annuity of $1 at 15 per
cent for seven periods from Table 4, Appendix 2, the present value of $20 000 annual
net cash flows would be calculated as follows:
= $20 000 × 4.1604
= $83 208
Net present value = Amount to be invested – Present value of annual net cash flows
= $91 280 – $83 208
= ($8 072)
b The rate of return is less than 15 per cent because there is a negative net present value.
c Present value factor for an annuity of $1:
= Amount to be invested
Annual net cash inflow
= $91 280
$20 000
= 4.564

Internal rate of return

= 12 per cent per annum (from Table 4, Appendix 2)

Problem 3
The following details are available for three projects:
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1 -5000 500 500 500 500 5500
2 -5000 1319 1319 1319 1319 1319
3 -5000 - - - - 8053
a. Calculate the net present value of each of these projects, and then rank them. Use discount rates of
5, 10 and 15 %.
b. Calculate the internal rate of return for each of the projects and then rank them.

1 Three projects
a Calculation of net present value (NPV) using rates of 5%, 10% and 15%
NPV @ 5 per cent

Year r = 5% Project 1 Project 2 Project 3

T0 1.0000 –$5 000 –$5 000 –$5 000 –$5 000 –$5 000 –$5 000
1 0.9524 $500 $476 $1 319 $1 256 –
2 0.9070 $500 $454 $1 319 $1 196 –
3 0.8638 $500 $432 $1 319 $1 139 –
4 0.8227 $500 $411 $1 319 $1 085 –
5 0.7835 $5 500 $4 309 $1 319 $1 033 $8 053 $6 310
NPV $1 082 $711 $1 310
Rank 2 3 1

NPV @ 10 per cent

Year r = 10% Project 1 Project 2 Project 3

T0 1.0000 –$5 000 –$5 000 –$5 000 –$5 000 –$5 000 –$5 000
1 0.9091 $500 $455 $1 319 $1 199 –
2 0.8264 $500 $413 $1 319 $1 090 –
3 0.7513 $500 $376 $1 319 $991 –
4 0.6830 $500 $342 $1 319 $901 –
5 0.6209 $5 500 $3 415 $1 319 $819 $8 053 $5 000
NPV $0 $0 $0
Rank =1 =1 =1

As shown above, at 10 per cent the NPV for all projects is zero. A zero NPV would
imply an equal ranking for Projects 1, 2 and 3.
 NPV @15 per cent

Year r = 15% Project 1 Project 2 Project 3

T0 1.0000 –$5 000 –$5 000 –$5 000 –$5 000 –$5 000 –$5 000
1 0.8696 $500 $435 $1 319 $1 147 –
2 0.7561 $500 $378 $1 319 $997 –
3 0.6575 $500 $329 $1 319 $867 –
4 0.5718 $500 $286 $1 319 $754 –
5 0.4972 $5 500 $2 734 $1 319 $656 $8 053 $4 004
NPV –$838 –$579 –$996
Rank – – –

If the project has to be undertaken irrespective of the sign of the net present value (e.g. they
relate to a pollution abatement investment), the lowest net present cost would be ranked the
highest-rated project. Thus, the ranking would be as follows:
Rank 1: Project 2 = –$579
Rank 2: Project 1 = –$838
Rank 3: Project 3 = –$996
However, if there was no requirement to invest in any project, as all projects have negative
NPVs, none would be accepted.
b As the internal rate of return (IRR) is determined when the present value of future
cash flows = the initial cost of the investment, the net present value would be zero.
Thus, as 10 per cent yields a zero NPV for all projects, then the IRR is 10 per cent.

Problem 4
Option A has a project investment cost of $20000 which will realise a $2000 salvage value on disposal at
the end of the fifth year. Over its five-year useful life, the investment will return an annual annuity in
arrears of $6000. The required rate of return is 10%
Use the data below to calculate:
a. the accounting rate of return
b. the payback period
c. the internal rate of return
d. the net present value
management subsequently revised its forecast of cash inflows and they will be as follows:
$
Year 1 6000
Year 2 7000
Year 3 12000
Year 4 3000
Year 5 10000
How would your answers differ if the net cash inflows were as shown above?
2 Option A
a Accounting rate of return: Depreciation
= (Initial cost – Estimated salvage value) ÷ Estimated life in years
= ($20 000 – $2 000) ÷ 5 years
= $3 600
Average net profit
= $6 000 – Depreciation
= $6 000 – $3 600
= $2 400

Average investment
= (Initial investment + Closing investment value) ÷ 2
= ($20 000 + $2 000) ÷ 2
= $11 000
Accounting rate of return on average investment:
= Average net profit ÷ Average investment
= $2 400 ÷ $11 000
= 21.82%.
Accounting rate of return on total investment:
= Average net profit ÷ Initial investment
= $2 400 ÷ $20 000
= 12.00%.
b Payback period:
= Initial investment ÷ Annual cash flows
= $20 000 ÷ $6 000
= 3⅓ years
c Internal rate of return (IRR):
For the purposes of estimating the likely IRR interest rate, the estimated residual value
at the end of the fifth year will be initially ignored. The discount factor for a project
with an initial investment cost of $20 000 and annual cash flows of $6 000 for five
years:
= $20 000 ÷ $6000
= 3.3333
Using Table 4, for five periods indicates the discount factor for an annuity in arrears
for five years at 15% is 3.3521 and 2.9906 at 20%. Thus, the IRR lies between 15%
and 20%. By trial and error, r = 17.2265%.
Proof:
 Year r = 17.2265% Project X
T0 1.0000 –$20 000 –$20 000
1 0.8530 $6 000 $5 118
2 0.7277 $6 000 $4 366
3 0.6208 $6 000 $3 725
4 0.5295 $6 000 $3 177
5 0.4517 $6 000 $2 710
0.4517 $2 000 $903
Net present value (NPV) $0

a Net present value (NPV) at 10% cost of capital.

Year r = 10.00% Project X

T0 1.0000 –$20 000 –$20 000
1 0.9091 $6 000 $5 455
2 0.8264 $6 000 $4 959
3 0.7513 $6 000 $4 508
4 0.6830 $6 000 $4 098
5 0.6209 $6 000 $3 726
0.6209 $2 000 $1 242
NPV $3 987

Proof
using Table 4, for five periods indicates the discount factor for an annuity in arrears
for five years at 10% is 3.7908. Thus, the NPV can be calculated as follows:
= [($6 000 x 3.7908) + ($2 000 x 0.6209) – $20 000
= [$22 744.80 = $1 241.80] – $20 000
= $23 986.60 – $20 000
=$3 986.60 (say $3987).

Answers based on different net cash

inflows: a Accounting rate of return:
Average net cash inflows
= ($6 000 + $7 000 + $12 000 + $3 000 +$10 000) ÷ 5 years
 = $38 000 ÷ 5 years
= $7 600
Average net profit
= $7 600 – $3 600
= $4 000
Accounting rate of return on average investment:
= Average net profit ÷ Average investment
= $4 000 ÷ $11 000
= 36.36%.
Accounting rate of return on total investment:
= Average net profit ÷ Initial investment
= $4 000 ÷ $20 000
= 20.00%.

b Payback period:

Project X
Year
Cash flows Investment recovered
T0 –$20 000 –$20 000
1 $6 000 –$14 000
2 $7 000 –$7 000
3 $12 000 $5 000

At the beginning of Year 3, $7 000 of the initial investment still remains to be

recovered (i.e. paid back). Assuming that monthly cash inflows are received in equal
amounts of $1 000 (i.e. $1 000 = $12 000 ÷ 12 months), then it will take a further
seven months for Project X’s investment cost to be fully paid-back. Thus, the payback
period is:
= 2 7/12 years (or 2 years and 7 months)
c Internal rate of return:

20 000  7 000 3 000

6 000 12 000 12 000
 (l  r) 2   (l  r) 4 
1 r (l  r) 3
(l  r) 5
By trial and error, r = 26.3195 per cent Proof:

Year r = 26.3195% Project X

T0 1.0000 –$20 000 –$20 000
1 0.7916 $6 000 $4 750
2 0.6267 $7 000 $4 387
3 0.4961 $12 000 $5 953
4 0.3928 $3 000 $1 178
5 0.3109 $10 000 $3 109
0.3109 $2 000 $622
NPV $0

d Net present value at 10%.

Year r = 10.00% Project X

T0 1.0000 –$20 000 –$20 000
1 0.9091 $6 000 $5 455
2 0.8264 $7 000 $5 785
3 0.7513 $12 000 $9 016
4 0.6830 $3 000 $2 049
5 0.6209 $10 000 $6 209
0.6209 $2 000 $1 242
NPV $9 756

Problem 6
Silver Corporation is evaluating five investment opportunities to draw upon a maximum of $150000 the
company’s cost of capital is 10 %. No investment is accepted if the payback period is greater than four
years. The company will only accept a maximum of three investment projects. The following investments
are being considered.
Investment Initial cost Expected returns Internal rate of
return
A 132000 $44000 per year for 5 years 19.8578%
B 100000 $33333 per year for 5 years 19.8573%
C 15000 $3750 per year for 10 years 21.4055%
D 20000 $5000 per year for 5 years 12.9775%
E 18000 $4500 per year for 6 years 12.9775%
Required:
a. Which of the five projects would be accepted using the NPV and Payback methods to screen
investments?
b. Would your recommendations change if surplus funds remaining from the capital budget could be
invested to return 5 per cent per annum after tax?
c. Discuss the benefits of using the payback method together with NPV or IRR.

Silver Corporation. Note

to instructors:
As will be apparent with the calculation of the net present value for Investment D, it must
have an internal rate of return lower that Silver Corporation’s cost of capital of 10%. The
IRR for Investment D is 7.92995% (say 7.9300%)

a Payback and net present value (NPV):

For instructor convenience, the discount factors for Problem 6: Silver Corporation are
provided below:

Amount in arrears r Annuity in arrears r

Period
=10% =10%
1 0.90909 0.90909
2 0.82645 1.73554
3 0.75131 2.48685
4 0.68301 3.16987
5 0.62092 3.79079
6 0.56447 4.35526
7 0.51316 4.86842
8 0.46651 5.33493
9 0.42410 5.75902
10 0.38554 6.14457
As each individual investment generates the same cash flow returns per annum, the payback period
is found by dividing each investment’s initial cash outlay by its annual cash returns. It is assumed
that each investment’s annual cash returns are received in equal monthly cash inflows.

Investment A:
Payback
= $132 000 ÷ $44 000
= 3 years.
Net present value for Investment A with an initial investment cost of $132 000 with a
cost of capital of 10% giving a discount factor for a $44 000 annuity in arrears for five
years = 3.79079.
= ($44 000 x 3.79079) – $132 000
= $166 795 – $132 000
= $34 795

Investment B:
Payback
= $100 000 ÷ $33 333
= 3 years.
Net present value for Investment B with an initial investment cost of $60 000 with a
cost of capital of 10% giving a discount factor for a $33 333 annuity in arrears for five
years = 3.79079.
= ($33 333 x 3.79079) – $100 000
= $126 358 – $100 000
= $26 358
 Investment C:
Payback
= $15 000 ÷ $3 750
= 4.00 years.
Net present value for Investment C with an initial investment cost of $15 000 with a
cost of capital of 10% giving a discount factor for a $3 750 annuity in arrears for 10
years = 6.14457.
= ($3 750 x 6.14457) – $15 000
= $23 042 – $15 000
= $8 042

Investment D:
Payback
= $20 000 ÷ $5 000
= 4.00 years.
Net present value for Investment D with an initial investment cost of $20 000 with a
cost of capital of 10% giving a discount factor for a $5 000 annuity in arrears for five
years = 3.79079.
= ($5 000 x 3.79079) – $20 000
= $18 954 – $20 000
= ($1 046)

Investment E:
Payback
= $18 000 ÷ $4 500
= 4.00 years.
Net present value for Investment E with an initial investment cost of $18 000 with a
cost of capital of 10% giving a discount factor for a $4 500 annuity in arrears for six
years = 4.35526.
= ($4 500 x 4.35526) – $18 000
= $19 599 – $18 000
= $1 599

The following table provides a summary of the payback and NPV results for each
investment:

Projects Investment cost NPV Payback

A $132 000 $34 795 3 years

 B $100 000 $26 358 3 years
C $15 000 $8 042 4 years
D $20 000 ($1 046) 4 years
E $18 000 $1 599 4 years

From the above table it is clear that Investment D would be immediately rejected as
whilst it satisfies the payback period screening criteria of four years, it has a negative
present value. Investments A and B could be accepted as they both pass the initial
payback investment screening criteria of four years, having payback periods of just
three years, and positive net present values. However, given that the cost of
Investment A is $132 000 and Investment B is $100 000, with a maximum of $150
000 to be invested only one can be recommended.
Of the remaining investments, Investments C and E both offer a positive NPV at
Silver Corporation’s 10 per cent cost of capital and with a payback period of four
years, each investment option also satisfies the payback period screening criteria of
four years.
Given that Silver Corporation has an investment budget of $150 000 and the capacity
to accept no more than three investments, the following table identifies three potential
investment portfolios that could be developed:

Bundle 1 Investment cost Net present value

Investment A $132 000 $34 795
Investment C $15 000 $8 042
Total invested and NPV $147 000 $42 837

Investment budget unallocated = $3 000

Bundle 2 Investment cost Net present value

Investment A $132 000 $34 795
Investment E $18 000 $1 599
Total invested and NPV $150 000 $36 394
 Investment budget unallocated = $0

Bundle 3 Investment cost Net present value

Investment B $100 000 $26 358
Investment C $15 000 $8 042
Investment E $18 000 $1 599
Total invested and NPV $133 000 $35 999

Investment budget unallocated = $17 000

Bundles 1 and 2 have Investment A as their dominant component with Bundle 1

including Investment C and Bundle 2 replacing Investment C with Investment E. As
the total net present value of Investment Bundle 1 (i.e. $42 837) outperforms Bundle 2
(i.e. $36 394), this would be preferred. Furthermore, as Investment Bundle 1 does not
use up the entire investment budget of $150 000, the surplus funds of $3 000 can be
used for other purposes. Investment Bundle 3 (i.e. Investments B, C and E) leaves $17
000 (i.e. $17 000 = $150 000 - $133 000) unallocated out of the total investment
budget of $150 000, it fails to generate a superior net present value than either of
Bundles 1 and 2.
b If surplus funds remaining unallocated from the capital budget of $150 000 were to
be invested to return 5 per cent per annum after tax, only Investment Bundles 1 and 3
need to be considered.
In theory, whenever funds are surplus to identified capital investment needs and
cannot be invested to earn a return above the firm’s cost of capital, they ought to be
returned to the providers of those funds. In such a case, in a manner similar to a share
buyback, decision making power over the use of those surplus funds are returned to
the original investors.
However, in practice where it is assumed that surplus funds can be eventually invested
to earn a return above the firm’s cost of capital, they may be retained and invested for
the short-term even though such an investment has a rate of return lower than the
firm’s cost of capital. For example, surplus funds might be invested in the short-term
money market even though money market returns are significantly lower than the
minimum hurdle rate a company will use for assessing investment proposals (i.e. the
weighted average cost of capital).
Whilst Silver Corporation has a weighted average cost of capital of 10 per cent and
should only accept an investment if it achieved an internal rate of return greater than
that, the question remains as to what happens to the funds that have were left unspent
by Investment Bundles 1 and 3. Assuming that Silver Corporation has no other
immediate or short-term investment options and does not plan to return these surplus
funds to investors, would be it be better for the company to invest its surplus funds at
an after tax return of 5 per cent per annum rather than not earning any return at all?
Although it might be expected that additional positive net present value investments
will eventually emerge over time or Silver Corporation returns the surplus funds to
investors, it is assumed that the funds are invested for a five year term at a
compounding interest rate after tax of 5 per cent per annum.
The net cash flows for Bundles 1 and 3 would be as follows:

Bundle 1: End of Year

Surplus funds = $3 000 1 2 3 4 5
Annual interest $150.00 $157.50 $165.38 $173.64 $182.33
Investment realised $3 000.00
Total cash flows $150.00 $157.50 $165.38 $173.64 $3 182.33

Bundle 3: End of Year

Surplus funds = $17 000 1 2 3 4 5
Annual interest $850.00 $892.50 $937.13 $983.98 $1 033.18
Investment realised $17 000.00
Total cash flows $850.00 $892.50 $937.13 $983.98 $18 033.18

Note that these cash inflows are not measured in present value terms. The internal rate
of return for each bundle is 5 per cent as this is the rate that returns the total present
value of the future cash inflows to an amount equal to the funds that were invested.
However, as Silver Corporation has a weighted average cost of capital of 10 per cent,
this should be the rate used to calculate the present value of each bundle’s cash
inflows.

Bundle 1: End of Year

Surplus funds = $3 000 1 2 3 4 5
10% discount factors 0.9091 0.8264 0.7513 0.6830 0.6209
Cash inflows $150.00 $157.50 $165.38 $173.64 $3 182.33
Present values $136.36 $130.17 $124.25 $118.60 $1 975.97
Total present value $2 485.35 (and negative NPV = $514.65)
Bundle 3: End of Year
Surplus funds = $17 000 1 2 3 4 5
10% discount factors 0.9091 0.8264 0.7513 0.6830 0.6209
Cash inflows $850.00 $892.50 $937.13 $983.98 $18 033.18
Present values $772.73 $737.60 $704.08 $672.07 $11 197.19
Total present value $14 083.67 (and negative NPV = $2 916.33)

Unsurprisingly, as each investment bundle has an internal rate of return of 5 per

cent, which is lower than Silver Corporation’s weighted average cost of capital
of 10 per cent, both have negative net present values.
Adding the present value of the cash inflows realised from the investment of
surplus funds to each of Bundles 1 and 3 results in Bundle 3 being preferred.

Bundle 1 Investment cost Net present value

Investment A $132 000 $34 795
Investment C $15 000 $8 042
Investment of surplus funds $3 000 $2 485
Total invested and NPV $150 000 $45 322

Bundle 3 Investment cost Net present value

Investment B $100 000 $26 358
Investment C $15 000 $8 042
Investment E $18 000 $1 599
Investment of surplus funds $17 000 $14 084
Total invested and NPV $150 000 $50 083

A scenario of investing surplus funds generating a rate of return lower

than the company’s weighted average cost of capital is theoretically
unsound. Similarly, it would be unusual in practice for any such
surplus funds to be invested for a term as long as five-years.