Exercise 31 Net Present Value Method and Annuity Method

The initial investment outlay of an investment project is 100,000. Use the following data Economic life 5 years Liquidation value 10,000 Tab. 3-6 Cash inflows and outflows of the investment project Where CIFt Current cash inflows in t COFt Current cash outflows in t The uniform discount rate is 5 . Is it a good idea to acquire this item Ascertain b) Using a financing and redemption plan, the value that would arise if the item were to be wholly financed by internal funds.

Exercise 33 Dynamic Investment Appraisal Methods

To maintain production of an important product, a metal processing company is forced to replace a piece of equipment. As there is a good order book, an expansion of production could also follow from this investment. There are two investment projects to choose from with the following data ( ) Liquidation value at the end of four periods Liquidation value at the end of four periods Tab. 3-8 Data for the investment projects I and II The uniform discount rate is 6 . a) Assess the relative...

Options Pricing Models

Characteristics, types and value of real options Companies can reduce the uncertainty associated with investments by exploiting their potential to adapt to future developments. For example, they might take an opportunity to delay an investment, change it, interrupt it temporarily, or abandon it altogether. Such scope for action, or project flexibility, can be called real options (as opposed to options on securities, which are financial options). Additionally, in a broader sense every investment...

References

Dugdale. 2001. Evaluating Investments in Advanced Manufacturing Technology A Fuzzy Set Theory Approach. British Accounting Review 33 (4) 455-489. Alesii, G. 2006. Payback Period and Internal Rate of Return in Real Options Analysis. Engineering Economist 51 (3) 237-257. Ang, J. S., J. H. Chua, and R. Sellers. 1979. Generating Cash Flow Estimates An Actual Study Using the Delphi Technique. Financial Management 8 (1) 64-67. Arrow, K. J. 1963. The Role of Securities in...

Static Model for Simultaneous Investment and Financing Decisions Dean Model

A simultaneous analysis of investment and financing alternatives is usually precipitated by interdependencies between them i.e. the availability and quality of financing choices might determine the feasibility and profitability of investment projects, and vice versa. Such interdependencies are taken into account in models of simultaneous investment and finance decision-making. Although the static model developed by Dean is relatively simplistic and, because only one period is considered, of...

Info

A) NPV 22,892.31 NPV > 0 The project is absolutely profitable c) Ann 5,287.55 Ann > 0 The project is absolutely profitable a) NPVa - 8,231.55 NPVB - 20,347.59 NPVC - 4,551.66 NPVb > NPVa > NPVC Project B is relatively profitable b) rA - 11.25 rB - 12.65 rC - 10.50 NPVI - 3,641.81 AnnI - 1,051 rI - 7.46 PPI - 3.88 years NPVII - 5,476.84 AnnII - 1,580.57 rII - 7.59 PPII - 3.78 years Net present value method NPVn > NPVj Project II is relatively profitable Annuity method Annn > Anni...

Critical Debt Interest Rate Method

The critical debt interest rate (CDIR) method, like the compound value method, assumes separate debt and credit interest rates. The critical debt interest rate serves as the target measure for this method. The critical debt interest rate is the rate that (with a given credit interest rate) results in a compound value of zero. This approach indicates the interest earned on capital tied-up over each period of the investment project, given a specified credit interest rate. The CDIR method and the...

Sensitivity Analysis

Sensitivity analysis aims to investigate the relationships between the various data and the target values of an investment appraisal and, if possible, the profitability of alternatives as well. The following questions are addressed by sensitivity analysis How does the target value change with given variations of an input measure or of several input measures (type A analysis) Which critical values must an input measure, or a combination of several input measures, achieve to reach a given target...

Decision Tree Method

The decision-tree method uses a dynamic model that includes several scenarios, their probabilities of occurring and the subsequent decisions that are contingent upon their occurrence. Since it is assumed that subsequent decisions will be based on these various scenarios and their differing expectations of the future, the impact of information access is also taken into account. The name of the method is derived from the undirected graph, the so-called decision-tree (see Figure 8-8), used to...

Exercise 54 Economic Life and Replacement Time

A company wants to determine the optimum economic life and replacement policy for its machines. a) Machine A has the following cash flows and liquidation values in dependence on its economic life tA (in '000) Tab. 5-13 Cash flows and liquidation values of machine A for different economic lives a) Determine the machines' optimum economic life and the related net present value when a1) There is no replacement. a2) There is one identical replacement. a3) The machines are replaced twice by...

Risk Analysis

First Order Stochastic Dominance

Risk analysis entails the representation of uncertain input measures as probability distributions. Taking into account the associations and interdependencies between input measures and between input and target measures, a probability distribution of possible values of a target measure is derived. This can be analysed to support decision-making under uncertainty. Risk analysis comprises the following steps 1. Formulation of a decision model. 2. Determination of the probability distributions for...

Exercise 52 Economic Life

A company in the metal processing industry is planning to acquire a new machine to produce special parts. Calculate its optimum economic life using the net present value method. The following data have been forecasted for the machine Initial investment outlay 500,000 Technical economic life 8 years Tab. 5-11 Cash flows and liquidation values for the new machine The uniform discount rate is 10 . a) Calculate the machine's net present value assuming that the machine will be in operation until the...

Decision Theory

Decision theory rules and criteria may be applied when alternative scenarios for uncertain environmental and company conditions are included in a model. This helps to consider the effects of uncertainty in the project appraisal and reveals the expected outcome of each project alternative under the various scenarios. Usually, only limited numbers of alternatives and scenarios are considered, each involving a distinct set of input data. The decision situation can be illustrated with the help of a...

Investment Planning as Part of the Capital Investment Decision Making Process

This book will present detailed calculative analyses that can be used to support capital investment decision-making, and there is no doubt that these sorts of rigorous financial analysis tools are important for supporting informed decisions. But, what else goes into capital investment decision-making in organisations As noted in the introduction, there is more to planning capital investment projects than financial analysis alone. A key theme of this chapter is the need for capital investment...

Models for Economic Life and Replacement Time Decisions 531 Overview

The 'lifetime' of an investment project - i.e. the period for which it operates - is crucial to its financial results and its profitability. A project's lifetime may be limited for different reasons. For example, legal determinations or contractual agreements might impose an upper limit on the economic life (e.g. in the form of a license period), or technical reasons might limit how long the investment project can fulfil its function (the project's 'technical life'). Technical life expiry might...

Strategic Analysis Tools Supporting the Capital Investment Decision Making Process

While important in themselves, even the most rigorous financial analysis tools cannot capture all of the strategic dimensions of capital investment projects, since many of them are not amenable to quantification. Consequently, researchers have looked for other analysis tools that do help decision-makers to incorporate these important aspects. Broadly, two avenues have emerged for developing alternative strategic investment appraisal techniques. The first involves modifying established...

Exercise 71 Dean Model for Simultaneous Financing and Investment Decisions

The choice is between the investment and finance projects below, each with their given cash flows, ajt or dit in '000 Tab. 7-7 Cash flows for the investment projects Tab. 7-7 Cash flows for the investment projects Tab. 7-8 Cash flows of for financing projects a For each project, calculate the internal rate of return IRR or the effective rate of interest. From this, deduce the capital supply and capital demand curves and draw these on a graph. Determine the optimum investment and financing...

List of Figures

1 -1 Classification of 1-2 Phases of the management process in 1-3 The capital investment decision-making 1-4 Characteristics of decision 1-5 Structure of the 2-1 Capital tie-up for investment project A with zero liquidation value 35 2-2 Capital tie-up of investment project B with positive liquidation value 36 3-1 Dynamic investment appraisal 3-2 Discounting net cash flows for the net present value method 55 3-3 The NPV of isolated investment projects as a function of the uniform discount 3-4...

Risk Adjusted Analysis

This method adjusts the data, i.e. the probable or expected values of the input measures used for investment appraisal, to incorporate the risks involved. For example, NPV calculations might be adjusted by raising the uniform discount rate or the cash outflows, or by shortening the economic life. This increases the probability that the project will achieve the calculated NPV result. A correction procedure has the disadvantage that only overall uncertainty is recognised - uncertainty is not...

Exercise 61 Utility Value Analysis

The copiers in a department are due for renewal. There is a choice between two types of copier that have the same basic technical functions. A financial profitability analysis shows no significant difference between the two. Carry out a utility value analysis with the following list of target criteria Target criteria Criteria weightings 1.1. Handling of the operating parts 10 1.2. Handling of paper loading 10 1.3. Frequency of faults 50 1.4. Finding and remedying faults 30 2. Service from...

Cost Comparison Method

For the cost comparison method CCM the target measure is, as the name suggests, the cost s of an investment project. It is assumed when using the CCM that the revenues of mutually exclusive investment alternatives and the option to forego the investment, if this is a permissible alternative are identical and that only the costs differ. Costs analysed include personnel expenditures wages, salaries, social expenditure etc. , cost of raw materials, depreciation, interest, taxes and fees, and costs...

Utility Value Analysis

This method seeks to analyse a number of complex alternatives, with the aim of ordering them according to the preferences of the decision-maker in a multidimensional target system. The ordering is carried out by calculating so-called utility values for the alternatives. In utility value analysis, multiple target criteria are weighted according to their importance to the decision-maker. The ability of the different alternatives here, the investment projects to fulfil each target is measured and...

Multi Attribute Utility Theory

The multi-attribute utility theory MAUT was originally developed for the analysis of multi-criteria problems under uncertain conditions, but it can also be applied in more predictable conditions of certainty , as assumed here. A characteristic feature of the method is that a multi-criteria problem is solved using cardinal utility functions or 'preference functions' based on substitution rates between the attributes. Using MAUT, cardinal utility functions are assigned to each attribute according...

Income Taxes and Investment Decisions

Taxes should be included in the analysis of investment projects since they may affect project profitability. Their consideration in the assessment of investment projects is illustrated here using both the net present value NPV and visualisation of financial implications VoFI methods. The influence of taxes on the profitability of investment projects is affected by several factors, including the form of the tax laws the legal form of the company in particular whether it has limited or unlimited...

Characteristics and Classification of Investment Projects

Investments can be considered from different points of view. According to the cash flow oriented perspective an investment project can be characterised by a stream of cash flows starting with an initial investment outlay - a cash outflow. The basic task for investment decision-making then will be to ascertain whether the future benefits from the investment will make the initial outlay worthwhile. An investment project is a series of cash inflows and outflows, typically starting with a cash...

Annuity Method

The annuity method AM uses the same discounted cash flow model as the NPV method. The only change is a different target measure, the annuity An annuity is a series of cash flows of equal amounts in each period of the total planning period. The annuity can be regarded as an amount that an investor can withdraw in every period when undertaking the investment project. The annuity of an investment project is equivalent to the NPV of that project, i.e. it is possible to equate both measures...

Average Rate of Return Method

The average rate of return ARR method differs from the PCM in regard to its target measure. The ARR method combines a profit measure with a capital measure to focus on the return expressed as a rate of interest earned on the capital invested. Both the profit measure and the capital measure can be defined differently. Average capital tie-up can be used as the capital measure, while the profit measure can be determined by adding average profit and average interest. This leads to the following...

Internal Rate of Return Method

Internal Rate Return Interpolation

The internal rate of return IRR method, considered next, is largely analogous to the NPV method. Only two assumptions are modified - concerning the reinvestment of free cash flow surpluses and the balancing of capital tie-up and economic life differences. Also, a different target measure is considered the internal rate of return. The internal rate of return is the rate that leads to a NPV of zero when applied as the uniform discount rate. The internal rate of return represents the interest...

Exercise 32 Net Present Value Method and Internal Rate of Return Method

A company has to decide between three investment projects. The characteristics of these are as follows Tab. 3-7 Characteristics of the three investment projects A, B, and C Tab. 3-7 Characteristics of the three investment projects A, B, and C The economic life of all three projects is 5 years. The uniform discount rate is 10 . a Calculate the net present values of the investment projects and assess the relative profitability of each. b Calculate the projects' internal rates of return.

Exercise 41 Compound Value Method Critical Debt Interest Rate Method and VoFI Method

Two investment projects are available, with the following relevant cash flows Tab. 4-2 Cash flows of the investment projects I and II a Use the compound value method to decide which project to accept. Assume a credit interest rate of c 5 and a debt interest rate of d 8 . Calculate the compound values of the two projects, assuming i Mandatory account balancing. ii Prohibited account balancing. b Calculate the critical debt interest rate, assuming i Mandatory account balancing. ii Prohibited...

Preface

Investment decisions are of vital importance to all companies, since they determine both their potential to succeed and their ultimate cost structure. Investments usually entail high initial cash outflows and thus tie up substantial funds. Sound investment decisions are important, therefore. Yet, due to a highly complex and rapidly changing business environment they remain a challenging management task. Effective appraisal methods are valuable tools to support investment decisions. They have...

Investment Appraisal Methods as Tools for Investment Planning

Appraisal Methods Time

Investment appraisal methods, as outlined in this book, are relevant to all the decisions that form part of the investment planning process. Understanding the different investment appraisal methods, their assumptions, limitations and possible usages will lead to an increased understanding of investment decision-making and an informed choice of methods. This should greatly enhance decision-making in regard to both single investment projects and investment programmes. The key questions to be...

Multi Tier Model of Simultaneous Investment and Financing Decisions Hax and Weingartner Model

The multi-tier model for simultaneous investment and financing decisions described in this section was developed by both Hax and Weingartner independently, in almost identical form. Most of the assumptions underlying Dean's model apply to this model also. However, unlike Dean's model, the Hax and Weingartner model is multi-tier in that the investment and financing projects considered may commence at different times. The objective included in the model is, again, to maximise the compound value...

Net Present Value Method

The net present value method focuses on selecting projects that maximise the 'net present value' NPV generated for the company Net present value is the net monetary gain or loss from a project, computed by discounting all present and future cash inflows and outflows related to the project. Using the NPV method, all future cash flows related to an investment project are discounted back to time 0 i.e. t 0 , taken to represent the start of the investment project. The NPV represents a specific kind...

Simultaneous Decision Making Models

Decisions about investment programmes often involve simultaneous choices about types and numbers of investment projects. Additionally, models used for simultaneous decision-making might need to accommodate choices within a range of company areas such as financing, production, sales, human resources and tax policy. In this chapter, the finance and production areas - because of their relevance and close connections with investment decisions - are selected to illustrate ways of supporting...

Compound Value Method

The compound value CV method is a dynamic investment appraisal method that uses the compound value as its target measure - i.e. all cash flows are compounded to the end of the investment project. The compound value is the overall net monetary gain or loss resulting from the investment project and is related to the end of its economic life. The method is characterised by three assumptions about the capital market. First, it is assumed that different interest rates exist a debt interest rate for...

The Assessment of Foreign Direct Investments

5.2.1 Special Characteristics of Foreign Direct Investments A foreign direct investment FDI includes the establishment, expansion or acquisition of sales outlets, storage or production plants abroad, and the direct influencing of the decisions made by a foreign company unit. The investing 'home' company sustains cash outflows in its domestic currency i.e. the 'home currency' to finance assets in the 'investment country', so that future cash flow surpluses may be achieved in the currency of that...

Static Payback Period Method

The target measure used for the static payback period SPP method is the time it takes to recover the capital invested in the project. It can be calculated based on average figures or on total figures. Average figures are used here. The payback period of an investment project is the period after which the capital invested is regained from the average cash flow surpluses generated by the project. The SPP method offers a measure of the risk connected with an investment. Judging the absolute and...

Visualisation of Financial Implications VoFI Method

The visualisation of financial implications VoFI method is based on the ideas of Heister 1962 that were later developed by Grob 1993 . Its defining feature is a comprehensive financial plan that considers all cash flows connected with an investment project. The VoFI comprehensive financial plan considers the economic consequences of an investment project, specifically in regard to The amounts and proportions of internal funds and debt capital used. The amounts and timing of debt redemption from...

Profit Comparison Method

As the name suggests, the profit comparison method PCM differs from the cost comparison method because it considers both the cost and revenues of investment projects. The target measure is the average profit, which is determined as the difference between revenues and costs. Apart from this difference, all of the other assumptions made in the CCM continue to apply for PCM. Absolute profitability is achieved if an investment project leads to a profit greater than zero. Relative profitability is...

Static Methods

This chapter considers simple 'static' analysis methods that assess the profitability of an investment for a time span of one average period. These methods focus on a single financial measure, so other target measures are ignored. The term 'profitability' is, unless otherwise specified, used throughout this book to indicate the achievement of positive or higher economic returns from an investment project. However, it should not be confused with the concept of 'accounting profit', which includes...