Methods of Ranking Investment Proposals Estimating Project Cash Flows Analysis of Projects with Uneven Lives Decision Tree

1. METHODS OF RANKING
INVESTMENT PROPOSALS
Financial Management Class
Ateneo De Manila University
(Graduate School of Business)
GROUP 3
Juliet Biglang-Awa
Picci Posadas
Vinz Racelis

2. Methods of
Ranking Investment Proposals
• Payback Period – number of years (or time period)
required to return the original investment.*
• Net Present Value (NPV) - the “difference amount”
between the sums of discounted: cash inflows and
cash outflows. It compares the present value of
money today to the present value of money in the
future, taking inflation and returns into account.**
• Internal Rate of Return (IRR) - The discount rate
found by trial and error which makes NPV = 0*

3. Payback Period Method
• Assume that two projects are being considered by a company. Each
requires a capital investment of $10,000. The marginal cost of capital is
10%. The net cash flows (i.e. net operating incomes after taxes plus the
depreciation allowance) from the investments A and B are shown in the
following table.

4. Payback Period Method
• Assume that two projects are being considered by a company. Each
requires a capital investment of $10,000. The marginal cost of capital is
10%. The net cash flows (i.e. net operating incomes after taxes plus the
depreciation allowance) from the investments A and B are shown in the
following table.
2 YEAR
PAYBACK!
4 YEAR
PAYBACK!

5. Payback Period Method
• Which is more desirable?
• Are they both the same?

6. Payback Period Method
• Disadvantage: taking into account time value of
money.
Money received in the
future is worth less than a
money received today!

7. Problems with Payback Period

8. Net Present Value Technique
1. NPV uses cash flows.
2. NPV uses all the cash
flows of the project.
3. NPV discounts the cash
flows properly.

9. Net Present Value Technique
1. NPV uses cash flows.
2. NPV uses all the cash
flows of the project.
3. NPV discounts the cash
flows properly.

10. Net Present Value (NPV)
Decision Criterion
Accept the
one i.e.
positive &
the highest
NPV
Accept all
with
positive
NPV.
SINGLE
PROJECT
Accept if
NPV is
positive
INDEPENDENT
PROJECTS
MUTUALLY EXCLUSIVE
PROJECTS

11. Internal Rate of Return (IRR)
Method
• The IRR is about as close as you can get to the NPV without actually being the NPV.
• Provides a single number summarizing the merits of a project.

12. Internal Rate of Return (IRR)
Decision Criterion
IRR rule leads to the same decisions as NPV if:
Cash outflow occurs only at time 0.
Only one project is under consideration.
Opportunity cost of capital is the same for all periods.
Threshold rate is set equal to opportunity cost of capital.

13. Internal Rate of Return (IRR)
Decision Criterion
Among the
projects having
IRR’s greater
than IRR*,
accept with the
highest IRR.
INDEPENDENT
PROJECTS
Accept if IRR
is greater than
some fixed
IRR*, the
threshold rate.
IRR* : rule leading to the same decisions as NPV if…
MUTUALLY EXCLUSIVE
PROJECTS

14. GENERAL RULES TO FOLLOW
ON NPV & IRR
First Cash Flow is
negative, all
remaining Cash
Flow are positive
Number of
IRR = 1
Accept: IRR > Rate
Reject: IRR < Rate
Accept: NPV > 0
Reject: NPV < 0
First Cash Flow is
positive and all
remaining Cash
Flows are
negative.
Number of
IRR = 1
Accept: IRR < Rate
Reject: IRR > Rate
Accept: NPV > 0
Reject: NPV < 0
Some Cash Flows
after first are
positive & some
Cash Flows after
first are negative.
Number of
IRRs = maybe
more than 1
No Valid IRR
Accept: NPV > 0
Reject: NPV < 0
PAGE 149 of of Corporate Finance, 9th ed (McGraw-Hill/Irwin)

15. Problems with
Internal Rate of Return (IRR)
IRR non-existent

16. Problems with
Internal Rate of Return (IRR)
Multiple IRR’s
=IRR(VALUE,GUESS)

17. Problems with
Internal Rate of Return (IRR)
Multiple IRR’s
=IRR(VALUE,GUESS)
If guess is omitted, it is assumed
to be 0.1 (10 percent).
If result is #NUM, try again with a
different value for guess.

18. Problems with
Internal Rate of Return (IRR)
Project ranking using IRR for mutually
exclusive projects:
Projects with Uneven Lives
Difference between time patterns, and
scale of the projects.
Work around is
Incremental Cash Flow (NPV & IRR)

19. PROFITABLITY INDEX
METHOD
If all
projects
are
positive,
how do
you make
a decision
out of it?
We use a
Profitability
Index type
of analysis
where:
• Annual
Return /
Investment
Issue of
absolute
amount is
not a
necessity.
Not the
primary
concern of
deciding
where to
invest.
Rather, as
a priority
project
over the
rest.
It is
always
the Rate.
~ Epimaco Densing III

20. PROFITABILITY INDEX
METHOD
PROJECT A is chosen because of the highest rate.

21. ESTIMATING
PROJECT CASH FLOWS
Financial Management Class
Ateneo De Manila University
(Graduate School of Business)
GROUP 3
Juliet Biglang-Awa
Picci Posadas
Vinz Racelis

22. WHAT IS CASH FLOW?
CASH
FLOW
Movement of money into or out of a
business, project, or financial product.
INFLOW: arise from financing,
operations and investing.
OUTFLOW: result from expenses.

23. ESTIMATING
PROJECT CASH FLOWS
COMPONENTS
Initial Cash Outlay
Operating Cash Flow over a Project's Life
Terminal-Year Cash Flow

24. ESTIMATING
PROJECT CASH FLOWS
INITIAL CASH
OUTLAY
OPERATING CASH
FLOW OVER A
PROJECT’S LIFE
Terminal-Year Cash Flow
How to determine the operating
cash flows per period?

25. INCREMENTAL CASH FLOW
or OPERATING CASH FLOW
In capital budgeting, the additional operating cash
flow that an organization receives from taking on a
new project.
Cash flows of a firm that change because of the
project are called “relevant” cash flows;
Any cash flows that does not change irrespective of
the acceptance/rejection of the project is “irrelevant”
to decision making and should not be considered.

26. INCREMENTAL CASH FLOW
or OPERATING CASH FLOW

27. RELEVANT VS IRRELEVANT
RELEVANT
IRRELEVANT
• OPPORTUNITY
COST
• SIDE EFFECT:
• EROSION
• SYNERGY
• SUNK COST
• ALLOCATED
COST
• INTEREST
EXPENSE

28. POINTS TO CONSIDER FOR
OPERATING CASH FLOW
• A cost that has already been incurred and thus cannot be
recovered.
• R&D, Market Research, Consultant’s Fees
SUNK
COST
• The cash flow foregone by using your resources in a particular
way.
• Resources that have multiple uses.
OPPORTUNITY
COST
• Erosion occurs when a new product reduces sales = cash flow
reduction on existing products.
• Synergy increases the cash flow of existing projects.
SIDE
EFFECTS
• Viewed as a cash outflow of a project if it is an
incremental cost of the project.
ALLOCATED
COSTS
• Net working capital is defined as current assets minus current
liabilities.
• As a cash outflow and inflow.
NET
WORKING
CAPITAL

29. DISCOUNTING:
NOMINAL OR REAL?
• Refers to the actual dollars
to be received or (paid out)
• Must be discounted at the
nominal rate.
NOMINAL
CASH
FLOW
• Refers to the cash flow’s
purchasing power.
• Must be discounted at the
real rate.
REAL
CASH
FLOW

30. DISCOUNTING:
NOMINAL OR REAL?
NOMINAL
DISCOUNTING
REAL
DISCOUNTING
Page 184 of Corporate Finance, 9th ed (McGraw-Hill/Irwin)
• The NPV is the same whether cash flows are expressed in
nominal or in real quantities.

31. SAMPLE EXERCISE:
Page 185 of Corporate Finance, 9th ed
(McGraw-Hill/Irwin)
•The NPV is the same whether cash flows are expressed in
nominal or in real quantities.

32. SAMPLE EXERCISE:
•The NPV is the same
whether cash flows are
expressed in nominal or in
real quantities.

33. NOMINAL APPROACH

34. REAL APPROACH

35. ALTERNATIVE APPROACHES
OPERATING CASH FLOW (OCF)
GIVEN
Top-Down
Approach
Bottom-Up
Approach
Tax Shield
Approach

36. ANALYSIS OF PROJECTS
WITH UNEVEN LIVES
Financial Management Class
Ateneo De Manila University
(Graduate School of Business)
GROUP 3
Juliet Biglang-Awa
Picci Posadas
Vinz Racelis

37. PROJECTS WITH
UNEVEN LIVES
Independent Project vs. Mutually Exclusive Projects
NPV and IRR can sometimes lead to conflicting
results in the analysis of mutually exclusive projects
Two methods used to make adjustments of mutually
exclusive projects:
Replacement-Chain Method and
Equivalent Annual Annuity Approach

38. PROJECTS WITH
UNEVEN LIVES
TYPES
OF
PROJECT
A Project whose cash flows have
no impact on the acceptance or
rejection of other projects is
termed as Independent Project.
A set of projects from which at
most one will be accepted is
termed as
Mutually Exclusive Projects.

39. NPV & IRR CONFLICT
Choose between both Projects:
Project A with 300% IRR and NPV of 22,000
Or
Project B with 160% IRR and NPV of 27,000?

40. NPV & IRR CONFLICT
Correct answer is Project B.
To justify the choice we’ll use Incremental IRR
And Incremental NPV

41. INCREMENTAL IRR
• Incremental Cash flows from choosing
Project B instead of Project A
• Incremental IRR is 67% higher than
Discount Rate of 25%

42. INCREMENTAL NPV
• Is it beneficial to invest 15,000 to receive
25,000 the following year?
• Yes, it is beneficial from the based on the
positive NPV of 5,000

43. GUIDELINES
MUTUALLY EXCLUSIVE PROJECTS
Compare the
NPVs of the
two choices.
Calculate the
incremental
NPV from
Project B vs
Project A
Compare
incremental
IRR to the
Discount
Rate.

44. GENERAL RULES TO FOLLOW
ON NPV & IRR
First Cash Flow is
negative, all
remaining Cash
Flow are positive
Number of
IRR = 1
Accept: IRR > Rate
Reject: IRR < Rate
Accept: NPV > 0
Reject: NPV < 0
First Cash Flow is
positive and all
remaining Cash
Flows are
negative.
Number of
IRR = 1
Accept: IRR < Rate
Reject: IRR > Rate
Accept: NPV > 0
Reject: NPV < 0
Some Cash Flows
after first are
positive & some
Cash Flows after
first are negative.
Number of
IRRs = maybe
more than 1
No Valid IRR
Accept: NPV > 0
Reject: NPV < 0
PAGE 149 of of Corporate Finance, 9th ed (McGraw-Hill/Irwin)

45. PROJECTS WITH
UNEVEN LIVES
Replacement-Chain Method
• The methodology involves determining the number of
years of cash flow (the project lives) for each of the
projects and creating a "replacement chain," or
iterations, to fill in the blanks in the shorter-lived project.
Equivalent Annual Annuity Approach
• Simpler method in analyzing projects with uneven lives.
• The constant annual cash flow generated by a project
over its lifespan if it was an annuity.

46. PROJECTS WITH
UNEVEN LIVES

47. Replacement-Chain Method
PROJECT CGTNG with a lifespan of 3 years
PROJECT VGQNC has a lifespan of 6 years UNEVEN LIVES

48. Replacement-Chain Method
• Analysis needs to be made into a common lifespan.

49. EQUIVALENT ANNUAL ANNUITY
APPROACH
Calculate each project's
NPV over its lifetime.
THREE STEP PROCESS TO
COMPARE PROJECTS:
Compute each project's EAA, such that the present value
of the annuities is exactly equal to the project NPV.
Compare each project's EAA and
select the one with the highest EAA.

50. EQUIVALENT ANNUAL ANNUITY
APPROACH
=PMT(Rate, Time Period, NPV)

51. THE DECISION TREE
Financial Management Class
Ateneo De Manila University
(Graduate School of Business)
GROUP 3
Juliet Biglang-Awa
Picci Posadas
Vinz Racelis

52. DECISION TREE
A graphical decision
making tool for describing:
the actions available
to the decision-maker;
the events that can
occur; and
the relationship
between the actions
and events.

53. DECISION TREE
Enable a business to quantify decision
making by:
placing numerical value
on potential outcomes;
comparing them and
selecting the best course
of action.

54. AVAILABLE OPTIONS
OPTION
TO EXPAND
• Has value if
demand turns
out to be
HIGHER
THAN
EXPECTED.
OPTION
TO ABANDON
• Has value if
demand turns
out to be
LOWER THAN
EXPECTED.
OPTION
TO DELAY
• Has value if the
underlying
variables are
changing with
a favorable
trend.

55. COMPOSITION AND
REPRESENTATION
Decision Point Decision Point
Decision
Node
Options
Consequences

56. Useful for operational
decision making.
Use of probability allows
flexibility.
Scientific/objective analysis
to decision making.
Encourages clear planning.
Reliant on the
accuracy of the data
used.
Requires qualitative
input to give
complete picture.
Probabilities only
estimated.
ADVANTAGES &
DISADVANTAGES

57. SAMPLE PROBLEM
Paris Hilton is a manager of a gadget factory, which has been quite successful the
past 3 years.
(?) To expand/not to expand the factory this year.
Cost to expand the factory is $1.5M.
If she does nothing and the economy stays good and people continue to buy lots of
gadgets:
she expects $3M in revenue; while only $1M if the economy is bad.
If she expands the factory:
she expects to receive $6M if economy is good and $2M if economy is bad.
She also assumes that there is a 40% chance of a good economy and a 60%
chance of a bad economy.
Mission: Draw a Decision Tree showing these choices.

58. SOLUTION:

59. SAMPLE PROBLEM CONTINUATION
A few days later, Paris was told that if
she expands, she can opt to either:
A) Expand the factory
further if the economy
is good which costs
$1.5M, but will yield
an additional $2M in
profit when economy
is good but only $1M
when economy is
bad,
B) abandon the
project and sell
the equipment
she originally
bought for $1.3M,
C) Or, do nothing.
Mission:
Draw a decision tree
to show these 3
options for each
possible outcome,
and compute the
NPV for the
expansion.

60. DECISION TREE

61. The Present Value of the Options
Good
Economy
• Expand further = $8M – $1.5M = $6.5M
• Do nothing = $6M
• Abandon Project = $3M + $1.3M = $4.3M
Bad
Economy
• Expand further = $3M – $1.5M = $1.5M
• Do nothing = $2M
• Abandon Project = $1M + $1.3M = $2.3M

62. NPV of the Project
So the NPV of Expanding the Factory is:
NPVExpand = [.4(6.5) + .6(2.3)] - $1.5M = $2.48M
Therefore the value of the option is
$2.48 (new NPV) – $2.1 (old NPV) = $380,000
You would pay up to this amount to exercise
that option.

63. RESOURCES
1. brown.edu/Departments/Engineering/Courses/en193-
194s7/Lectures/engine90-crawford-DECISION-MAKING.ppt
2. capitalbudgetingtechniques.com/independent-and-mutually-exclusive-projects/
3. Contemporary Engineering Economics 5TH Edition © 2010.
4. Corporate Finance, 9th ed (McGraw-Hill/Irwin)
5. en.wikipedia.org/wiki/Net_present_value
6. faculty.philau.edu/MalhotraD/642Cash%20Flow%20Estimation.ppt
7. idc-online.com/technical_references/pdfs/project.../fm10.pdf
8. investopedia.com/exam-guide/cfa-level-1/corporate-finance/comparing-projects-
unequal-lives.asp
9. investopedia.com/terms/e/equivalent-annual-annuity-approach.asp
10. investopedia.com/terms/i/incrementalcashflow.asp
11. investopedia.com/terms/r/replacement-chain-method.asp
12. office.microsoft.com/en-001/excel-help/irr-HP005209146.aspx
13. people.hss.caltech.edu/~jlr/courses/BEM103/Readings/JWCh05.pdf
14. richdad.com/apps-games/apps-games-landing
15. smallbusiness.chron.com/estimate-cash-flow-project-65327.html
16. termsexplained.com/760410/incremental-cash-flow
17. www2.gsu.edu/~fnccwh/pdf/Chap008vid.pdf
18. youtube.com/watch?v=VUx_V9XNtIU