Chapter 8

Textbook:
Fundamentals of Corporate Finance (Hillier cs)

Jan H. Jansen
E-mail: jan.jansen@han.nl

Investment Decision
Nature of an investment decision:
Investment amount (large amount)
Expected, Future Cash Flows
Outflows (Costs)
Inflows (Revenues)
Discount factor
Real interest rate
Inflation
Risk
Economic life vs technical life
Scrap value / Residual value

Stages in an investment decision

Determine
investment
funds
available

Identify
profitable
project
opportunities

Evaluate the
proposed
project

Approve the
project

Monitor and
control the
project

Investment decision criteria

Payback Period
Average Accounting Return / ROI
Net Present Value
Profitability Index
Internal Rate of Return / IRR
Discounted Payback / Break even time

Payback Period

The amount of time required for an

investment to generate cash flows
sufficient to recover its initial cost

Average Accounting Return / ROI

An investments average net income

divided by its average book value

Net Present Value (NPV)

NPV

The process of valuing an investment by

discounting its future cash flows
An investment should be accepted if the net
present value is positive and rejected if it is
negative.

Advantages of NPV

Uses Cash
Flows
Cash Flows
are better
than
Earnings
(Cash is a
fact, profit is
an opinion)

Uses all Cash

Flows

Discounts
Cash Flows

Other
approaches
ignore cash
flows beyond
a certain date

Fully
incorporates
the Time
Value of
Money

Profitability Index

Discounted Payback / Break even time

The length of time required for an

investments discounted cash flows
to equal its initial cost

Internal Rate of Return (IRR)

The discount rate (irr) that makes

the NPV of an investment zero

Internal Rate of Return (IRR)

IRR equation: Polynomial (degree of n)

The possibility that more than one
discount rate will make the NPV of an
investment zero

Structure Excel model

Results
Calculations

Cash Inflows
Cash Outflows
Data & Assumptions

How to build an Excel model

Worksheet 1 (Project name)

Project name
Version & Date
Authors

Worksheet 2 (Results)

Investment amount
Economic life
Decision criteria

Worksheet 3 (Data)

Data
Assumptions

Worksheet 4 (COF)

Cash Outflows

Worksheet 5 (CIF)

Cash Inflows

Worksheet 6 (NCF)

Net Cash Flows

Investment case

Investment 50,000,000
Scrap value: 0
Expected economic life: 10 years
Expected Real Interest rate: 3%
Expected Inflation: 2.5%
Risk mark up: 1.5%
Annual Revenues: 10,000,000
Annual Costs: 2,000,000

Calculate

Discount factor
Payback Period
Average Accounting Return / ROI
Net Present Value
Profitability Index
Internal Rate of Return / IRR
Discounted Payback / Break even time

Should we invest or not?

Excel functions

^
COUNTIF
NPV
IRR

Results

PBP

7years

ROI

12,0%

NPV

5.778.955,65

PI
IRR
BET

11,56%
9,6%
9years

Decision criteria: Pros & Cons

Payback Period
Average Accounting Return / ROI
Net Present Value
Profitability Index
Internal Rate of Return / IRR
Discounted Payback / Break even time