Financial Management in IB

Investment Criteria

Investment Criteria
STRATEGIC ASSET ALLOCATION
Any firm has a huge number of possible investments.
What fixed assets should we buy?
Each possible investment is an option available to the firm.

Some options are valuable and some are not.

Financial managers should be able to identify which are worth
undertaking.

Investment Criteria
Net Present Value
An investment is worth undertaking if it creates value for its owners
NPV is the difference between an investments market value and its
costs.
It is a measure of how much value is created or added today by
undertaking the investment.
To find present value of an investment we use discounted cash flow
valuation.

An investment should be accepted if the net present value is positive

and rejected if it is negative.

Investment Criteria
EXAMPLE
Suppose we are asked to decide whether a new project should be
undertaken. Based on projected sales and costs, we expect that the
cash flows over the five-year life of the project will be $2,000 in the first
two years, $4,000 in the next two, and $5,000 in the last year. It will cost
about $10,000. We use a 10 percent discount rate. What should we do?

Investment Criteria
The Payback Rule
The payback is the length of time it takes to recover initial investment.
An investment is acceptable if its payback period is less than some
predefined number of years.
EXAMPLE: Projected cash flows from a possible investment
Year

Cash Flow

$100

200

500

The project costs $500. What is the payback period for this
investment? Assume cash flows are received uniformly throughout the
year.
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Investment Criteria
The Payback Rule
The payback rule is easy to understand, but:
Time value of money is completely ignored
It fails to consider any risk differences

We may take investments that are actually worth less that they
costs and reject profitable long-term investment.
Payback period is break even in an accounting sense, but not in an
economic or financial sense.

Investment Criteria
The Discounted Payback
It is a length of time until the sum of the discounted cash flows is
equal to the initial investment.
It is a time it takes to break even in an economic or financial sense.
We get our money back along with interest we could have earned
elsewhere.
EXAMPLE
We have an investment that costs $300 and has cash flows of $100 per
year for five years. Compute the payback and discounted payback if we
require a 12.5 percent return on new investments.

Investment Criteria
The Discounted Payback
Advantages

Disadvantages

Includes time value of money

May reject positive NPV investments

Easy to understand

Difficult to set out cutoff point.

Prefers liquidity

Ignores cash flows beyond the cutoff

date

Does not accept negative estimated

NPV investments (if all cash flows
are positive)

Biased against long-term projects,

such as research and development

Investment Criteria
The Internal Rate of Return
It is closely related to NPV.
It depends only on the cash flows of the project (therefore internal)
IRR is the discount rate that makes the NPV of an investment zero.

An investment is worth undertaking if the IRR exceeds the required

return.
To show the relationship between NPV and various discount rates we
may draw the net present value profile where IRR is break even once
more.
EXAMPLE
Assume investment that costs $100 and has cash flow of $60 per year
for two years. What is the IRR? Draw the NPV profile.

Investment Criteria
The Internal Rate of Return Nonconventional CF
If we have projects with more negative cash flows we may find more
internal rate of returns and we do not know which one is correct.
EXAMPLE
Suppose we have a mining project that requires a $60 investment. Our
cash flow in the first year will be $155. In the second year, the mine will
be depleted, but we will have to spend $100 to restore the terrain. What
is the IRR?
In this case the IRR does not provide good answer.
There are lot of projects with huge negative cash flows at the end of
the project (for example plants).

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Investment Criteria
The IRR Mutually exclusive Investments
If two investments are mutually exclusive, then taking one means that
we cannot take the other.
For example if you own one corner lot, then you can build a gas station
of apartment building, but not both.
EXAMPLE
Consider the following cash flows from two mutually exclusive
investments and decide which one to chose.
YEAR

Project A -$100

50

40

40

30

Project B -$100

20

40

50

60
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Investment Criteria
The IRR Mutually exclusive Investments
The IRR for A (24 percent) is larger than the IRR for B (21 percent).
However, if you compare the NPVs, you will see that the result depends
on our required return.
For smaller required returns NPV of B is larger and for higher required
returns NPV of A is higher.
We may even compute crossover point. This is the point at which
NPVs of both projects are equal.
We should always chose for the project with higher NPV regardless of
the returns.

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Investment Criteria
The Modifies Internal Rate of Returns
To address some of the problems we may modify the cash flows first
and then compute IRR.
3 Methods:
The Discounting Approach all negative cash flows are discounted
back to the present.
The Reinvestment Approach we compound all cash flows except the
first out to the end of the project and the calculate the IRR.

The Combination Approach negative cash flows are discounted

whereas positive cash flows are compounded.

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Investment Criteria
The Profitability Index
It is called benefit-cost ratio.
Present value of future cash flows divided by the initial investment.
It measure the value created per dollar invested.

If NPV is positive the PI is greater than 1. If NPV is negative the PI is

lower than 1.

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