INVESTMENT PROJECTS AND BUSINESS INVESTMENTS by Assist. Zornitsa Yordanova, PhD

1. INVESTMENT PROJECTS AND BUSINESS INVESTMENTSbyAssist. Zornitsa Yordanova, PhD

2. Content • Investment Life cycle • Capital Budgeting • Investment projects • Investment ideas • Real options • Investment strategy

3. Investing versus financing

4. Real or financial investments • Real assets • Used to produce goods and services; property; plant and equipment; human capital. • The net wealth of an economy is the sum of its real assets. • Financial assets • Claims on real assets or claims on real income

5. Relationship between risk and return

6. Investment Life cycle

7. Investment Life cycle

8. Investment Life cycle

9. Capital budgeting General questions on capital budgeting • Meaning of capital budgeting • Significance • Capital budgeting process • Investment criteria • Methods of capital budgeting

10. Capital budgeting What is capital budgeting? • The process of determining which real investment projects should be accepted and given an allocation of funds from the firm. • The process through which different projects are evaluated. • To evaluate capital budgeting processes, their consistency with the goal of shareholder wealth maximization is of utmost importance.

11. Capital budgeting What is capital budgeting? • The firm’s formal process for the acquisition and investment of capital. It involves firm’s decisions to invest its current funds for addition, disposition, modification and replacement of fixed assets. • Long term planning for making and financing proposed capital outlays. • Consists in planning development of available capital for the purpose of maximizing the long term profitability of the concern

12. Capital budgeting Significance of capital budgeting • The success and failure of business mainly depends on how the available resources are being utilized. • Main tool of financial management • All types of capital budgeting decisions are exposed to risk and uncertainty. • They are irreversible in nature.

13. Capital budgeting Significance of capital budgeting • Capital rationing gives sufficient scope for the financial manager to evaluate different proposals and only viable project must be taken up for investments. • Capital budgeting offers effective control on cost of capital expenditure projects. • It helps the management to avoid over investment and under investments.

14. Capital budgeting What is capital budgeting includes? • Analysis of potential projects. • Long-term decisions; involve large expenditures. • Very important to firm’s future.

15. Capital budgeting Main Steps in capital budgeting? • Estimate cash flows (inflows & outflows). • Assess risk of cash flows. • Determine r = WACC for project. • Evaluate cash flows.

16. Capital budgeting The process of capital budgeting? 1. Project generation: Generating the proposals for investment The investment proposal may fall into one of the following categories: • Proposals to add new product to the product line, • Proposals to expand production capacity in existing lines. • Proposals to reduce the costs of the output of the existing products without altering the scale of operation. • Sales campaigning, trade fairs people in the industry, R and D institutes, conferences and seminars will offer wide variety of innovations on capital assets for investment.

17. Capital budgeting The process of capital budgeting? 2. Project Evaluation: it involves two steps: • Estimation of benefits and costs: the benefits and costs are measured in terms of cash flows. The estimation of the cash inflows and cash outflows mainly depends on future uncertainties. The risk associated with each project must be carefully analyzed and sufficient provision must be made for covering the different types of risks. • Selection of an appropriate criteria to judge the desirability of the project: It must be consistent with the firm’s objective of maximizing its market value. The technique of time value of money may come as a handy tool in evaluation such proposals.

18. Capital budgeting The process of capital budgeting? 3. Project Selection: No standard administrative procedure can be laid down for approving the investment proposal. The screening and selection procedures are different from firm to firm.

19. Capital budgeting The process of capital budgeting? 4. Project Evaluation: Once the proposal for capital expenditure is finalized, it is the duty of the finance manager to explore the different alternatives available for acquiring the funds. He/she has to prepare capital budget. Sufficient care must be taken to reduce the average cost of funds. He/she has to prepare periodical reports and must seek prior permission from the top management. Systematic procedure should be developed to review the performance of projects during their lifetime and after completion.

20. Capital budgeting The process of capital budgeting? 4. Project Monitoring and controlling: The follow up, comparison of actual performance with original estimates not only ensures better forecasting but also helps in sharpening the techniques for improving future forecasts.

21. Capital budgeting Factors influencing capital budgeting

22. Capital budgeting Methods of capital budgeting Traditional methods • Payback period • Accounting rate of return method • Return of investment Discounted cash flow methods • Net present value method • Profitability index method • Internal rate of return

23. Capital budgeting Choosing the Optimal Capital Budget • Finance theory says to accept all positive NPV projects. • Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects: • An increasing marginal cost of capital. • Capital rationing

24. Capital budgeting Increasing Marginal Cost of Capital • Externally raised capital can have large flotation costs, which increase the cost of capital. • Investors often perceive large capital budgets as being risky, which drives up the cost of capital. • If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.

25. Capital budgeting Capital Rationing • Capital rationing is a method used to select a project mix in a situation when the total funds available for investment are less than total net initial investment needed by all the projects under consideration. • Capital rationing is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a budget. Companies may want to implement capital rationing in situations where past returns of an investment were lower than expected.

26. Capital budgeting Capital Rationing • Capital rationing occurs when a company chooses not to fund all positive NPV projects. • The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.

27. Investment projects What is the difference between independent and mutually exclusive projects? Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.

28. Cash flow Normal Cash Flow Project: • Cost (negative CF) followed by a series of positive cash inflows. Onechange of signs. Non-normal Cash Flow Project: • Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine.

29. Cash flow Inflow (+) or Outflow (-) in Year 0 1 2 3 4 5 N NN - + + + + + N - + + + + - NN - - - + + + N + + + - - - N - + + - + - NN

30. Discounted Cash Flow (DCF) Techniques • The main DCF techniques for capital budgeting include: Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI) • Each requires estimates of expected cash flows (and their timing) for the project. • Including cash outflows (costs) and inflows (revenues or savings) – normally tax effects are also considered. • Each requires an estimate of the project’s risk so that an appropriate discount rate (opportunity cost of capital) can be determined. • The discussion of risk will be deferred until later. For now, we will assume we know the relevant opportunity cost of capital or discount rate. • Sometimes the above data is difficult to obtain – this is the main weakness of all DCF techniques.

31. Discounted Cash Flow (DCF) Techniques Net Present Value (NPV) • Method: NPV = PVinflows – PVoutflows • If NPV ≥ 0, then accept the project; otherwise reject the project.

32. Discounted Cash Flow (DCF) Techniques Net Present Value (NPV) • Strengths • Resulting number is easy to interpret: shows how wealth will change if the project is accepted. • Acceptance criteria is consistent with shareholder wealth maximization. • Relatively straightforward to calculate • Weaknesses • Requires knowledge of finance to use. • An improper NPV analysis may lead to the wrong choices of projects when the firm has capital rationing – this will be discussed later.

33. Discounted Cash Flow (DCF) Techniques Internal Rate of Return (IRR) • IRR is the rate of return that a project generates. Algebraically, IRR can be determined by setting up an NPV equation and solving for a discount rate that makes the NPV = 0. • Equivalently, IRR is solved by determining the rate that equates the PV of cash inflows to the PV of cash outflows. • Method: Use your financial calculator or a spreadsheet; IRR usually cannot be solved manually. • If IRR ≥ opportunity cost of capital (or hurdle rate), then accept the project; otherwise reject it.

34. Discounted Cash Flow (DCF) Techniques Internal Rate of Return (IRR) • Strengths • IRR number is easy to interpret: shows the return the project generates. • Acceptance criteria is generally consistent with shareholder wealth maximization. • Weaknesses • Requires knowledge of finance to use. • Difficult to calculate – need financial calculator. • It is possible that there exists no IRR or multiple IRRs for a project and there are several special cases when the IRR analysis needs to be adjusted in order to make a correct decision (these problems will be addressed later).

35. Discounted Cash Flow (DCF) Techniques Profitability Index (PI) • Method: • Note: PI should always be expressed as a positive number. • If PI ≥ 1, then accept the real investment project; otherwise, reject it.

36. Discounted Cash Flow (DCF) Techniques Profitability Index (PI) • Strengths • PI number is easy to interpret: shows how many $ (in PV terms) you get back per $ invested. • Acceptance criteria is generally consistent with shareholder wealth maximization. • Relatively straightforward to calculate. • Useful when there is capital rationing (to be discussed later). • Weaknesses • Requires knowledge of finance to use. • It is possible that PI cannot be used if the initial cash flow is an inflow. • Method needs to be adjusted when there are mutually exclusive projects (to be discussed later).

37. Discounted Cash Flow (DCF) Techniques Summary and Conclusion • The DCF techniques, NPV, IRR, and PI, are all good techniques for capital budgeting and allow us to accept or reject investment projects consistent with the goal of shareholder wealth maximization. • Beware, however, there are times when one technique’s output is better for some decisions or when a technique has to be modified given certain circumstances – these cases will be discussed in the next lecture.

38. Other Techniques for evaluation investment projects Payback period • The number of years required to recover a project’s cost; • or how long does it take to get the business’s money back?

39. Other Techniques for evaluation investment projects Payback period Strengths of Payback: • Provides an indication of a project’s risk and liquidity. • Easy to calculate and understand. Weaknesses of Payback: • Ignores the TVM. • Ignores CFs occurring after the payback period.

40. Other Techniques for evaluation investment projects Payback period Cons • It is based on principle of rule of thumb, • Does not recognize importance of time value of money, • Does not consider profitability of economic life of project, • Does not recognize pattern of cash flows, • Does not reflect all the relevant dimensions of profitability.

41. Financial calculators • Mortgage Calculators • Auto Calculators • Credit Card Calculators • Home Equity Calculators • Investment Calculators • Retirement Calculators • Savings Calculators (cost of living) • Cash flow calculators

42. Project selection methods Consider a scenario in which the organization you are working for has been handed a number of project contracts. But due to resource constraints, the organization cannot take up all the projects at once. Therefore, a decision has to be made as to which project needs to be taken up to maximize profitability. This is where Project Selection Methods come into play. There are various methods to help you choose a project. These can be divided into two categories, namely: 1.Benefit Measurement Methods 2.Constrained Optimization Methods

43. Project selection methods Benefit Measurement Methods Benefit Measurement is a project selection technique that is based on the present value of estimated cash outflow and inflow. Cost benefits are calculated and then compared to other projects to make a decision.

44. Project selection methods Benefit Measurement Methods • Benefit/Cost Ratio - as the name suggests, is the ratio between the Present Value of Inflow or the cost invested in a project to the Present Value of Outflow which is the value of return from the project. Projects that have a higher Benefit Cost Ratio or lower Cost Benefit Ratio are generally chosen over others. • Economic Model - The EVA or Economic Value Added is the performance metric that calculates the worth-creation of the organization while defining the return on capital. It is also defined as the net profit after the deduction of taxes and capital expenditure. If there are several projects assigned to a project manager, the project that has the highest Economic Value Added is picked. The EVA is always expressed in numerical terms and not as a percentage.

45. Project selection methods Benefit Measurement Methods • Scoring Model - The scoring model is an objective technique wherein the project selection committee lists relevant criteria, weighs them according to their importance and their priorities and then adds the weighted values. Once the scoring of these projects is completed, the project with the highest score is chosen. • Discounted Cash Flow - It's well-known that the future value of money will not be the same as it is today. For example, $20,000 will not carry the same worth 10 years down the line from today. Thus, during calculations of cost investment and ROI, one must consider the concept of discounted cash flow.

46. Project selection methods Benefit Measurement Methods • Opportunity Cost - The Opportunity Cost is cost that is being given up when picking another project. During project selection, the project that has the lower opportunity cost is chosen. Generally, most organizations use Benefits Measurement Methods to lead them into making a decision. • Payback Period • Net Present Value • Internal Rate Of Return

47. Project selection methods Constrained Optimization Methods Constrained Optimization Methods, also known as the Mathematical Model of Project Selection, are used for larger projects that require complex and comprehensive mathematical calculations.