Capital Investment Decisions

Net Present Value

The net present value (NPV) method can be a very good way to analyze the profitability of an investment
in a company, or a new project within a company. But like many methods in finance, it is not the end-all,
be-all solution -- it carries a few unique advantages and disadvantages that may not make it useful for
some investment decisions.

How net present value works

The basic principle of the net present value method is that a money in the future is not worth as much as
one money today. Thus, net present value calculates the present value of future cash flows in excess of
the present value of the investment outlay.

Suppose you have an opportunity to invest R15,000 to expand your business. You believe that this
investment will generate R3,000 in cash flow for the next 10 years. Your capital cost is 10% per year (this
is also known as the discount rate).

The table below shows the cash flows (positive and negative) that we expect this project to create, and
present value of each cash flow over the 10-year period.

Time Cash Flows Present Value

0 -15,000 -15,000
1 3,000 2727.27
2 3,000 2,479.34
3 3,000 2,253.94
4 3,000 2,049.04
5 3,000 1,862.76
6 3,000 1,693.42
7 3,000 1,593.47
8 3,000 1,399.52
9 3,000 1,272.29
10 3,000 1,156.63
Net Present Value @ 10% 3,433.70

By discounting every future R3,000 cash flow back at a rate of 10%, and subtracting the initial cash outlay
of R15,000, we arrive at a net present value of R3,433.70 for this project. Under the NPV method, you
should choose to do this project, since the net present value is positive.

Advantages of the NPV method

The obvious advantage of the net present value method is that it takes into account the basic idea that a
future ran is worth less than a rand today. In every period, the cash flows are discounted by another period
of capital cost.
The NPV method also tells us whether an investment will create value for the company or the investor,
and by how much in terms of rands. In the example above, we found that the R15,000 investment would
increase the company's value by R3,443.70 when all cash flows were discounted back to today.

The final advantages are that the NPV method takes into consideration the cost of capital and the risk
inherent in making projections about the future. In general, a projection of cash flows 10 years into the
future is inherently less certain than cash flows projected next year. Cash flows that are projected further
in the future have less impact on the net present value than more predictable cash flows that happen in
earlier periods.

Disadvantages of NPV

The biggest disadvantage to the net present value method is that it requires some guesswork about the
firm's cost of capital (This previous sentence is from an investor’s point of view. A company should know
its own cost of capital). Assuming a cost of capital that is too low will result in making suboptimal
investments. Assuming a cost of capital that is too high will result in forgoing too many good investments.

In addition, the NPV method is not useful for comparing:

- two projects of different size;

- two projects of with unequal useful lives;
- two projects with different costs of capital.

For example, a R1 million project will likely have a much higher NPV than a R1,000 project, even if the
R1,000 project provides much higher returns in percentage terms. If capital is scarce -- and it usually is --
the NPV method is a poor method to use because projects of different size are not immediately
comparable based on the output.

Note: Go online and in your textbooks, and read up on the advantages and disadvantages of NPV (and the
other methods) to give yourself a better understanding.
Internal Rate of Return

Advantage: Finds the Time Value of Money

Internal rate of return is measured by calculating the interest rate at which the present value of future
cash flows equals the required capital investment (NPV = 0). The advantage is that the timing of cash flows
in all future years are considered and, therefore, each cash flow is given equal weight by using the time
value of money.

Advantage: Simple to Use and Understand

The IRR is an easy measure to calculate and provides a simple means by which to compare the worth of
various projects under consideration. The IRR provides any small business owner with a quick snapshot of
what capital projects would provide the greatest potential cash flow. It can also be used for budgeting
purposes such as to provide a quick snapshot of the potential value or savings of purchasing new
equipment as opposed to repairing old equipment.

Advantage: Hurdle Rate Not Required

In capital budgeting analysis, the hurdle rate, or cost of capital, is the required rate of return at which
investors agree to fund a project. It can be a subjective figure and typically ends up as a rough estimate.
The IRR method does not require the hurdle rate, mitigating the risk of determining a wrong rate. Once
the IRR is calculated, projects can be selected where the IRR exceeds the estimated cost of capital.

Disadvantage: Ignores Size of Project

A disadvantage of using the IRR method is that it does not account for the project size when comparing
projects. Cash flows are simply compared to the amount of capital outlay generating those cash flows.
This can be troublesome when two projects require a significantly different amount of capital outlay, but
the smaller project returns a higher IRR.
For example, a project with a R100,000 capital outlay and projected cash flows of R25,000 in the next five
years has an IRR of 7.94 percent, whereas a project with a R10,000 capital outlay and projected cash flows
of R3,000 in the next five years has an IRR of 15.2 percent. Using the IRR method alone makes the smaller
project more attractive, and ignores the fact that the larger project can generate significantly higher cash
flows and perhaps larger profits.

Disadvantage: Ignores Future Costs

The IRR method only concerns itself with the projected cash flows generated by a capital injection and
ignores the potential future costs that may affect profit. If you are considering an investment in trucks,
for example, future fuel and maintenance costs might affect profit as fuel prices fluctuate and
maintenance requirements change. A dependent project may be the necessity to purchase vacant land
on which to park a fleet of trucks, and such cost would not factor in the IRR calculation of the cash flows
generated by the operation of the fleet.

Disadvantage: Ignores Reinvestment Rates

Although the IRR allows you to calculate the value of future cash flows, it makes an implicit assumption
that those cash flows can be reinvested at the same rate as the IRR. That assumption is not practical as
the IRR is sometimes a very high number and opportunities that yield such a return are generally not
available or significantly limited.

Payback and Discounted Payback Method

The Payback Method

The object of the payback method is to determine the number of years that it takes to recover the initial
investment.

Advantages of the Payback Method

The most significant advantage of the payback method is its simplicity. It's an easy way to compare several
projects and then to take the project that has the shortest payback time. However, the payback has
several practical and theoretical drawbacks.

Disadvantages of the Payback Method

Ignores the time value of money (unless we are using the discounted payback method): The most serious
disadvantage of the payback method is that it does not consider the time value of money. Cash flows
received during the early years of a project get a higher weight than cash flows received in later years.
Two projects could have the same payback period, but one project generates more cash flow in the early
years, whereas the other project has higher cash flows in the later years. In this instance, the payback
method does not provide a clear determination as to which project to select.

Neglects cash flows received after payback period: For some projects, the largest cash flows may not
occur until after the payback period has ended. These projects could have higher returns on investment
and may be preferable to projects that have shorter payback times.
Ignores a project's profitability: Just because a project has a short payback period does not mean that it
is profitable. If the cash flows end at the payback period or are drastically reduced, a project might never
return a profit and therefore, it would be an unwise investment.

Does not consider a project's return on investment: Some companies require capital investments to
exceed a certain hurdle of rate of return; otherwise the project is declined. The payback method does not
consider a project's rate of return.

They payback method is a useful tool to use as an initial evaluation of different projects. It works very well
for small projects and for those that have consistent cash flows each year. However, the payback method
does not give a complete analysis as to the attractiveness of projects that receive cash flows after the end
of the payback period. And it does not consider the profitability of a project nor its return on investment.

Accounting Rate of Return

Advantages:

1. Accounting rate of return is simple and straightforward to compute.

2. It focuses on accounting net operating income. Creditors and investors use accounting net
operating income to evaluate the performance of management.

Disadvantages:

1. Accounting rate of return method does not take into account the time value of money. Under this
method a dollar in hand and a dollar to be received in future are considered of equal value.
2. Cash is very important for every business. If an investment quickly generates cash inflow, the
company can invest in other profitable projects. But accounting rate of return method focus on
accounting net operating income rather than cash flow.
3. The accounting rate of return does not remain constant over useful life for many projects. A
project may, therefore, look desirable in one period but undesirable in another period.
Practice Question

Two mutually exclusive projects; Alma and Balta, are currently being considered by Atom limited. The
discount rate for both projects is 10% and all funds can be invested at that rate.

The following table shows the cash flows for each year:

Cash flows

Alma Balta

Year (R) (R)

0 (50 000) (50 000)

1 25 000 0

2 25 000 8 000

3 20 000 25 000

4 10 000 65 000

Determine which of the two projects should be selected using the Net present
Q.3.1 value;

Q.3.2 Calculate the Internal rate of return Balta;

Q.3.3 Calculate the payback period and discounted payback period for Alma;

Q.3.4 List any three advantages of net present value method over the payback.

Q.3.5 Calculate the Profitability Index for Alma and Balta

Answers

Q3.1 Alma Balta

Cash PVIF PVIF

Year flow @10% PV Year Cash flow @10% PV

0 (50 000) 1 (50 000) 0 (50 000) 1 (R50 000)

1 25 000 0.909 22 725 1 0 0.909 0

2 25 000 0.826 20 650 2 8 000 0.826 6 608

3 20 000 0.751 15 020 3 25 000 0.751 18 775

4 10 000 0.683 6 830 4 65 000 0.683 44 395

NPV 15 225 NPV 19 778

Balta should be selected as it has a higher NPV than Alma.

Q.3.2 Year Cash flows Discount NPV Discount NPV

R factor@25% R factor @10% R

0 (50 000) 1.000 (50 000) 1.000 (50 000)

1 0 0.800 0 ½ 0.909 0

2 8 000 0.640 5 120 ½ 0.826 6 608

3 25 000 0.512 12 800 ½ 0.751 18 775

4 65 000 0.410 26 650 ½ 0.683 44 395

Net present value (5 430) 19 778

IRR = 10 + 19 778 x 15

19 778 + 5 430
 = 10 + 11.76

~ 21.76%

IRR ~ 10% + 19778/25208 x (25%-10%) ~ 21.76%

ALTERNATIVE

-50 000 CF0, 0 CF1, 8 000 CF2, 25 000 CF3, 65 000 CF4, IRR ~ 20.9%

Payback Period A

Q.3.3 Cash Cum CF Payback

Year flow A A Period

0 (50 000) -50 000 0

]1 25 000 -25 000 1

2 25 000 0 2.0 years

3 20 000

4 10 000

Discounted Payback Period A

Cash Cum CF Payback

Year flow A PVIF PV A Period

0 (50 000) 1 -50 000 -50 000 0

1 25 000 0.909 22 725 -27 275 1

2 25 000 0.826 20 650 -6 625 2

3 20 000 0.751 15 020 0.441 2.44 years

4 10 000 0.683 6 830

Q.3.4 - Risk of projects can be calculated;

- Takes into account changes in the time value of money;
 - It considers all cash flows of a project;
- It shows that value being created/destroyed by the project.

Q.3.5 Profitability Index for Alma = PV of future cash flows/Initial Investment

= (22,725 + 20,650 + 15,020 + 6,830) / 50,000
= 65,225 / 50,000
= 1.3045
Cash
flow
Year Alma PVIF PV

0 (50 000) 1 -50 000

1 25 000 0.909 22 725

2 25 000 0.826 20 650

3 20 000 0.751 15 020

4 10 000 0.683 6 830

Profitability Index for Balta = PV of future cash flows/Initial Investment

= (0 + 6,608 + 18,775 + 44,395) / 50,000
= 69,778 / 50,000
= 1.39556

Cash
flow
Year Balta PVIF PV

0 (50 000) 1 -50 000

1 0 0.909 0

2 8,000 0.826 6,608

3 25,000 0.751 18,775

4 65,000 0.683 44,395