Corporate Finance

Tutorial 2
Ben Varian 2014
Investment Criteria
Q2. Chapter 6-Q28 Comparing Investment Criteria You are a senior manager at Airbus
and have been authorized to spend up to 200,000 for projects. The three projects you
are considering have the following characteristics:.
Project A: Initial investment of 150,000. Cash flow of 50,000 at year 1 and 100,000
at year 2. This is a plant expansion project, where the required rate of return is 10 per
cent.
Project B: Initial investment of 200,000. Cash flow of 200,000 at year 1 and
111,000 at year 2. This is a new product development project, where the required rate
of return is 20 per cent.
Project C: Initial investment of 100,000. Cash flow of 100,000 at year 1 and
100,000 at year 2. This is a market expansion project, where the required rate of
return is 20 per cent.
Assume the corporate discount rate is 10 per cent. Please offer your
recommendations, backed by your analysis.
Ben Varian 2014
Figures
Year 0 Year 1 Year 2 Required
Rate of
Return
Investment A -150000 50000 100000

10%
Investment B -200000 200000

111000

20%
Investment C -100000 100000 100000

20%
Ben Varian 2014
Payback
Diagram:

Cash Inflow


Time


Cash Outflow
0
2
X
1
x
3
x x
Payback Occurs
at Time 2

Ben Varian 2014
Payback Continued
Investment A:


0
2
-1500000
1
50000 10000
0
Payback Occurs at
Year 2
Ben Varian 2014
Payback Continued
Investment B

0
2
-2000000
1
200000 111000
Payback Occurs at
Year 1
Ben Varian 2014
Payback Continued
Investment C
0
2
-1000000
1
100000 10000
0
Payback Occurs at
Year 1
Ben Varian 2014
Internal Rate of Return
Internal rate of return (IRR) is the interest rate at
which the net present value of all the cash flows
(both positive and negative) from a project or
investment equal zero. Internal rate of return is
used to evaluate the attractiveness of a project or
investment.
IRR is the discount rate when NPV = 0
0 = -(Initial Investment) + Cash Flows / (1 + IRR)
Ben Varian 2014
IRR Continued
Investment A:
i) 0 = -150000 + 50000/(1+IRR) +
(100000/(1+IRR)
2
)
ii) In this instance IRR is 0 because the projects
cash flows do not exceed its initial investment.
iii) As the rate of return does not exceed 10% -
Reject

Ben Varian 2014
IRR Continued
Investment B
i) 0 = -200000 + 200000/(1+IRR) +
(111000/(1+IRR)
2
)
ii) 1
st
Guess: 30% Rate
iii) -200000 + 200000/1.3 + 111000/1.3
2

iv) -200000 + 153846.15 + 65680.47= 19526.62
v) Positive NPV means raise discount rate


Ben Varian 2014
IRR Continued
Investment B Continued
i) 2
nd
Guess: 50% Rate
ii) -200000 + 200000/1.5 + 111000/1.5
2

iii) -200000 + 133333.33 + 49333.33 = -17333.34
iv) Negative NPV means lower discount

Ben Varian 2014
IRR Continued
Investment B Continued
i) 3rd Guess: 40% Rate
ii) -200000 + 200000/1.4 + 111000/1.4
2

iii) -200000 + 142857.14 + 56632.65 = -510.21
iv) -510 0 Therefore IRR = 40%
v) IRR is also over 20% so proceed

Ben Varian 2014
IRR Continued
Investment C
i) 1
st
Guess: 50% Rate
ii) -100000 + 100000/1.5 + 100000/1.5
2

iii) -100000 + 66666.67 + 44444.44 = 11111.11
iv) IRR is positive so raise discount rate

Ben Varian 2014
IRR Continued
Investment C
i) 2
nd
Guess: 60% Rate
ii) -100000 + 100000/1.6 + 100000/1.6
2

iii) -100000 + 62500 + 39062.50 = 1562.50
iv) IRR is positive so raise discount rate

Ben Varian 2014
Investment C
i) 3
rd
Guess: 62% Rate
ii) -100000 + 100000/1.62 + 100000/1.62
2

iii) -100000 + 61728.40 + 38103.95 = -167.65
iv) -167.65 0 Therefore IRR = 62%
v) IRR Greater than 20% so can proceed

Ben Varian 2014
Incremental IRR
Formula =
Discount Rate that gives NPV of 0
Difference in Initial Investment (Larger Project
Smaller) D
i
Plus Difference in Subsequent Cashflows D
c

Divided by 1 + Incremental IRR
0 = -D
i
+ D
c
/1+IRR



Ben Varian 2014
Incremental IRR Continued
Date 0 Date 1 Date 2
Project B -200000 200000 111000
Project A -150000 50000 100000
Difference -50000 150000 11000
Project B to Project A
Ben Varian 2014
Incremental IRR Continued
Project B to Project A
i) 0 = -50000 + 150000/(1+IIRR) + 11000/(1+IIRR)
2
ii) Guess = 200% IIRR
iii) -50000 + 150000/(1+2) + 11000/ (1+2)
2
iv) -50000 + 50000 + 1222.22 = 1222.22
v) Positive NPV = Increase Discount Rate
Ben Varian 2014
Incremental IRR Continued
Project B to Project A
i) Guess = 210% IIRR
ii) -50000 + 150000/(1+2.1) + 11000/ (1+2.1)
2
iii) -50000 + 48387.10+ 1144.64= -468.26
iv) Negative NPV = Decrease Discount Rate

Ben Varian 2014
Incremental IRR
Project B to Project A
i) Guess = 207% IIRR
ii) -50000 + 150000/(1+2.07) + 11000/ (1+2.07)
2
iii) -50000 + 48859.93 + 1167.12 = 27.05
iv) 27.05 0 Therefore IIRR B A = 207%

Ben Varian 2014
Incremental IRR Continued
Year 0 Year 1 Year 2
Project B -200000 200000 111000
Project C -100000 100000 100000
Difference -100000 100000 11000
Ben Varian 2014
Incremental IRR Continued
Project B to Project C
i) Guess = 10% IIRR
ii) -100000 + 100000/(1+0.1) + 11000/(1+0.1)
2
iii) -100000 + 90909.09 + 9090.90 = -0.01
iv) IIRR B C = 10%

Ben Varian 2014
Incremental IRR Continued
Year 0 Year 1 Year 2
Project A -150000 50000 100000
Project C -100000 100000 100000
Difference -50000 -50000 0
Ben Varian 2014
Incremental IRR Continued
Project A to Project C
i) Guess = 0% IIRR
ii) -50000+ -50000/(1+0) + 0/(1+0)
2
iii) -50000 + -50000 + 0 = 0
iv) IIRR A C = 0%

Ben Varian 2014
Profitability Index
Profitability Index = Present Value of Cash Flows
Subsequent to Initial Investment / Initial
Investment
i) Present Value = Cashflow/Discount
ii) Project A: (50000/1.1) + (100000/1.1
2)
=
iii) 45454.55 + 82644.63 = 128099.18
iv) 128099.18/150000 = 0.85 PI
Ben Varian 2014
Profitability Index Continued
i) Project B: (200000/1.1) + (111000/1.1
2)
=
ii) 181818.18 + 91735.54 = 273553.72
iii) 273553.72/200000 = 1.37 PI


Ben Varian 2014
Profitability Index Continued
i) Project C: (100000/1.1) + (100000/1.1
2)
=
ii) 90909.09 + 82644.63 = 173553.72
iii) 173553.72 / 100000 = 1.74 PI

Ben Varian 2014
Profitability Index Continued


Cashflows
PV @ 10%

PI
C
0
C
1
C
2

Project A -150000 50000 100000 128.099.19 0.85
Project B -200000 200000 111000 273553.72 1.37
Project C -100000 100000 100000 173553.72 1.74
Ben Varian 2014
NPV
Ben Varian 2014
NPV Continued
Project A: -150000 + 50000/1.1 + 100000/1.1
2
-150000 + 45454.55 + 82644.63 = -21900.82

Project B: -200000 + 200000/1.1 + 111000/1.1
2
-200000 + 181818.18 + 91735.54 = 73553.72

Project C: -100000 + 100000/1.1 + 100000/1.1
2
-100000 + 90909.09 + 82644.63 = -73553.72



Ben Varian 2014
NPV Corrections
Wrong rate used for Projects B & C:
Project B: -200000 + 200000/1.2 + 111000/1.2
2
-200000 + 166666.67 + 77083.33 = 43750

Project C: -100000 + 100000/1.2 + 100000/1.2
2
-100000 + 83333.33 + 69444.44 = 52777.77


Ben Varian 2014
Overall
A B C Implication
s
Payback 2 Years 1 Year 1 Year (Project A is
out either
B or C)
IRR 0% 40% 62% C
Incremental
IRR
(To C) 0% To C 10%
To A 207%
N/A B
PI 0.85 1.37 1.74 C
NPV -
21900.83
43750 52777.77 C
Ben Varian 2014
Overall Continued
Project C performs best across the spread of
Investment Rules therefore I would select Project
C.
Ben Varian 2014