Managerial Economics

NATIONAL AND KAPODISTRIAN UNIVERSITY OF ATHENSFacultyof Economics Departmentof Business Economicsand FinanceCenter of Financial StudiesLaboratory for InvestmentApplications

Internal Audit Program

Course: Managerial Economics and Financial Management - Chapter 6

Instructor: Panayotis AlexakisIn cooperation with:

Under the aegis of:

Managerial Economics and Financial ManagementChapter 6: Capital Budgeting, Investment Finance and the Enterprise ValueContents of presentation:Capital BudgetingCapital Budgeting without restrictions in the availability of capital The net present value methodThe internal rate of return methodThe method of Revenue-Cost ratioThe pay back period method

22Managerial Economics and Financial ManagementMutually exclusive investments and the differences between NPV and IRR methodsThe choice investment projects under restrictions in the availability of capitalDefinition of an investment and investment analysisThe enterprise valueCorporate financeCorporate finance with equity capitalCorporate finance with borrowed funds

33. Capital Budgeting. IntroductionCapital budgeting refers:to an investment plan which is expected to affect an enterprise, both with respect to its operation and its economic situation in the long-term, that is beyond a year. It includes the process for decision making to invest financial capital possessed by the company, as well as the choice between alternative investment projects. Such investments refer to installations and equipment with respect to replacement or extension, the development and differentiation of business activities, the acquisition of business units and the implementation of a marketing and sales plan, among others.

4Capital Budgetingto a demanding and difficult activity, as it extends to many years in the future, under conditions of uncertainty. It includes predictions and estimations on basic economic sizes of the company, such as sales, operating cost, cost of capital and investment returns. Due to the lack of perfect knowledge, what is aimed at is, in the best case, to reach an approximation of inflows and outflows related to an investment project.Therefore, the importance of preparing such a budgeting becomes obvious for the viable operation of a company, as the correct decisions for future investments lead to the maximization of the company value. 5Capital BudgetingThe company must weigh the increased expenditure related to the investment projects against the lack of necessary installations and equipment in case it does not implement these projects, leading to a fall in production and firm size, loss of competitiveness and market share.Factors such as the ability to predict sales in the future, as well as the technological developments in production determine the planning time horizon. Therefore, the more predictable future sales are or the longer the period for the development of a product is, the longer is the planning period.6Capital BudgetingA company decides or rejects the implementation of an investment project on the basis of its evaluation. For this reason, various methods of investment appraisal have been developed, analysed below. The prioritisation of the investment projects is equally important, in particular in cases of restrictions in funding or investment projects considered as mutually exclusive. Capital budgeting aims at deciding and implementing those decisions which lead to the maximization of the company value. 7Capital BudgetingThis in turn presupposes that the suggested investment projects are to the benefit of the company, while the preferred one is determined between mutually exclusive investment projects. Therefore, the decisions are taken having answered before these questions.

8B. Capital budgeting without restrictions in the availability of capitalThe first case examined is where the investment funds provided to the company are not limited, either because the company has sufficient savings or ability to raise capital, through the capital market without restrictions (external finance).So, the company through capital budgeting decides whether to accept or reject each of the available investment projects, on the basis of its contribution to the company objectives related to the maximization of the company profits and value.9Capital budgeting without restrictions in the availability of capitalFour are the most usual methods for the prioritisation of investment projects.The net present value (NPV), that is the derivation of the present value of future income flows discounted by the cost of capital minus the present value of outflows.The internal rate of return (IRR) method, that is the derivation of the interest rate equalizing the present value of future returns to the initial investment cost.The revenue cost (R/C) ratio of an investment project, that is the ratio of the present value of future returns to the investment cost.The payback period (PP) method, that is the time period required in order for the company to retrieve the initial cost of the project.

10The net present valueIn this method, the discounted values of future revenue and cost flows are added, related to the implementation of an investment project. The present value of the cost flows is deducted from the present value of the future revenues. The equation of the net present value is:

(1)

11The net present value methodwhere,x1, x2 . xn represent the net revenue inflows (net cash flows)g is the opportunity cost, that is the interest rate on the return obtained to the company, if it invested its capital amount to the best possible alternative activity, facing the same risk and uncertainty levels.n is the investment life spanEo is the initial investment cost, assuming that all investment cost is due at the time of the investment implementation.

12The net present valueEquation (1) assumes that the cost refers only to the initial period. If it extends to other years, the present value of cost and that of revenues is estimated for each year. In general, a positive NPV means that the investment project becomes accepted as the present value of the revenues is larger to the present value of the costs. The investment project is rejected when NPV is negative.It should be noted that xn are exclusively linked to the investment project, that is they form the difference between the additional revenues stemming from this investment and the additional expenditure from its implementation. They also include flows such as tax discounts due to depreciation, capital grants and subsidies related to the project, during its time horizon.

13The net present valueFinally, it should be stressed that it is assumed that there is full information on the side of the company in relation to the investment projects, both for foreseen revenues and costs. However, usually, uncertainty prevails for these revenue and cost flows. Therefore, instead of the NPV the expected NPV is estimated as the latter was defined in the relevant chapter, reaching in this way to an expected present value of flows, and, provided that it is positive, the project becomes accepted.14The internal rate of returnThe discount rate which equalises the present value of future cash inflows to the initial investment cost forms the internal rate of return, which is defined as follows:

(2)

Where i is the IRR of the project.

15The internal rate of returnBoth, the initial cost and the future flows are known to the company, except for i which equalises the two sizes, that is the IRR. Equation (2) is the same with equation (1) if g is defined as the rate that makes NPV zero. In NPV method g is defined and then NPV follows, while the reverse happens in IRR, that is NPV is given and i is derived at the rate that renders NPV zero. IRR is estimated by trial and error techniques.

16The internal rate of returnThe next step is for the company to compare its IRR to the opportunity cost and provided that the first is higher than the second the investment project is approved for implementation. When the opposite happens the project is rejected as it is not to the benefit of the company to borrow funds due to the forthcoming loss, while own funds should be invested to alternative uses that are to render a higher return. In this case the opportunity cost forms the best alternative return for the company.

17The internal rate of returnSo, a company aiming at profit and value maximization from a series of investment projects, will advance the projects whose IRR exceeds the cost of capital. In the following table a series of possible investment projects is presented, assuming a 15% cost of capital. Therefore, the company is to accept projects 1 to 4, rejecting the rest of the projects. Its total investment is to reach 1.65 m euros.

18The internal rate of returnPossible Investment Projects (euros)Investment projectsCost Cumulative amount IRR (%)1600,000600,000212150,000750,000203600,0001,350,000184300,0001,650,000175450,0002,100,000146600,0002,700,000127750,0003,450,0001119The Revenue-Cost ratioUnder this method an investment project is selected when the R/C ratio is above unity. That is, the present value of future cash inflows is divided by the initial investment cost.

20The Revenue-Cost ratioWhen , then the present value of revenues exceeds the present value of costs. Note:This, and the other two methods above are compatible among them, suggesting the selection of the same project.

21The pay back periodThis method, used frequently, refers to the time period that is necessary for recovering the initial cost of an investment out of the revenues related to this investment. The following table presents two investment projects with a time horizon of 5 years. If the initial cost of each project is 95,000 euros, A has a 3 year and B a 4 year payback period. In case that a firm sets the payback period to 3 years, B is rejected while A becomes accepted.

22The pay back periodRevenues of investment projects (euros)

TimeProject AProject B150,00012,000220,00015,000330,00035,000410,00040,000510,00080,00023The pay back periodDisadvantages:This method has a medium term dimension. It doesnt take into account the revenues beyond the payback period, while it could lead to accepting a project that is to bring less revenue in the long-term compared to another project, in case the main return of an investment requires more years. Usually, investments related to long-term company planning are linked to a long payback period and high returns only after passing a certain number of years. Therefore, this method implies a disadvantage for investments which may be significant and crucial for the future viable operation of a company, as it is the case for product differentiation, product development, or expansion to new markets.24The pay back periodAlso, problems could emerge in terms of the time value of money for projects which have the same cost and payback periods, as it is shown in the following table. Both C and D are equally accepted, assuming an initial cost of 4,000,000 euros. Project C though should be preferred as it renders a higher cash flow compared to D.25The pay back periodInvestment projects and payback period (euros)

TimeCD13,000,0001,000,00021,000,0003,000,00031,000,0001,000,00026The pay back periodAdvantages:Easiness in use, useful for cases of alternative small investment projects as more complicated methods may result cost exceeding the estimated benefit or for cases where uncertainties with respect to the course of a market or an economy. In practice, this method is utilised in association with NPV and IRR for the selection of an investment project, as a small payback period reduces, in terms of time, the risk to which the invested capital is exposed.

27Mutually exclusive investment projects and differences between NPV and IRR In general, a company is frequently asked to decide either between mutually exclusive projects, using the same resources and production factors, or to choose from a series of investment projects for which a limited amount of funds is available. So, the issue of project prioritisation emerges in order to select those that are to maximize the companys objectives.28Mutually exclusive investments and differences between NPV and IRRIn NPV, the positive NPV projects are suggested while the mutually exclusive projects are prioritised on the basis of the NPV level. In IRR, projects with an IRR higher than the opportunity cost are suggested for approval, while in case of mutually exclusive projects these are prioritised according to the level of IRR. Then, it holds that if a projects IRR of an investment project is higher than its cost of capital, then NPV will be positive too. Therefore, one is led to the same result either under IRR or NPV method.

29Mutually exclusive investments and differences between NPV and IRRHowever, in certain cases, the two methods could lead to diverging results and prioritise 2 projects differently. 30Mutually exclusive investments and differences between NPV and IRRThe question is what companies should decide when problems emerge between mutually exclusive projects. Experience indicates that, finally, it is NPV that leads to the final decision taking. The project with the higher NPV is selected, as it is NPV that determines how much, as a result of the investment, the value of the company is raised, which in turn is related to its long-term objectives.31D. Choice of investment projects under restrictions in capital availabilityCapital availability forms a significant factor in investment decision making. Under no limitation in the availability of funds companies accept projects with positive NPV, while mutually exclusive projects are prioritised on the basis of the higher NPV. A company aiming at value maximisation proceeds in investment undertaking until the marginal investment scores a zero NPV. 32The choice of investment projects under restrictions in capital availability.However, in most cases companies do not have an unlimited amount of funds. Therefore they do not proceed according to previous procedure, while at the same time they aim at value maximisation. So, in this case the company adopts these projects, which maximize the returns of the limited resources. 33The choice of investment projects under restrictions in capital availability.Projects are prioritised according to NPV and become accepted from the beginning, starting with the highest NPV project, until the last project covered by the remaining available capital funds.For the utilisation of any possible remaining available funds projects of lower cost and lower prioritisation are selected until all available funds are utilised.

34E. Definition of an investment and investment analysisDefinition:The investment of resources means the use of resources in the present, leading to future benefits. In this meaning economists distinguish between investment and consumption. In contrast to investment, consumption uses resources which bring benefits to the present. Investment means avoidance of present consumption or shift of present consumption to the future. It becomes evident that investment implies the transfer of available resources from the present to the future.

35Definition of an investment and investment analysisFor a company, investment is a cash outflow which promises cash inflows in the future. In other words, it is the exchange of present with future values. The general framework of cash flows linked to an investment is:

Placement in year(0):-Eo(investment expenditure for resources)

Inflows in future years x1, x2 . xN

36Definition of an investment and investment analysisWhere N is the last period where inflows are taking place from the investment (Eo). Therefore, N defines the time horizon of the investment. In order for this exchange of resources to be evaluated (appraised) economically one should estimate the equivalent of the future resources promised by the investment in present value (PV).

37Definition of an investment and investment analysisPV reflects the present value equivalent of future investment inflows and is called value of the investment. Eo refers to expenditure that has to be realised in the present for the undertaking of investment. Therefore, the economic appraisal of the investment takes place through the comparison of these two sizes, deriving the NPV of the investment:

38Definition of an investment and investment analysis NPV=PV-Eo (4)

So if

PV>Eo then NPV>0 (4a)PV=Eo then NPV=0 (4b)PV NPVa > NPVc

Taking into account the budget cost (up to 105,000 euros), we end as follows:

123Exercise 1 TOTAL: 103,000

The remaining 2,000 euros are invested on public sector bonds with an 8,5% return.

Investment ProjectCostB28,000D40,000A35,000124Exercise 2YEARINVESTMENTCOST(m)CAPACITY(1)(000)PROFITMARGIN(2)(000)CASH FLOW (3)=(1)(2)(m)PROJECT VALUEINTERESTFACTOR0-55(=-45-10)---551-62---620.869524,5002,500(P-C)11,2500.756136,5002,50016,2500.6575410,0002,50025,0000.5717510,0002,50025,0000.4971610,0002,50025,0000.4323710,0002,50025,0000.3759810,0002,50025,0000.3269925(5+20)10,0002,50050,0000.2842NPV-20,400125Exercise 2The investment is not desirable, since it presents an NPV0 this investment project should be undertaken.

142ProjectABCD

Initial cost200,000270,000170,000244,000

Cash flows:

Year 1-24,40052,600112,000-50,000

Year 2-17,00068,80064,00021,200

Year 3153,20097,20037,20096,400

Year 4124,800113,00024,800193,000

Year 547,00044,00011,00068,000

Year 619,00020,000037,400

Year 1Year 2

Probability DemandNCFProbability DemandNCF

0.25High75,0000.25High90,000

0.50Regular50,0000.50Regular70,000

0.25Low25,0000.25Low50,000

Cash flows from the production of energy

Year 1Year 2

ProbabilitySeasonNCF ()ProbabilitySeasonNCF ()

0.25Summer80,0000.25Summer100,000

0.25Autumn20,0000.25Autumn25,000

0.25Winter30,0000.25Winter40,000

0.25Spring20,0000.25Spring25,000

YearCapitalInstallmentInterestCapital returnedCapital at end of period

1100,00014,646.3110,0004,676.3195,323.69

295,323.6914,676.319,532.375,143.9490,179.75

390,179.7514,676.319,017.975,685.3484,521.41