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chapter LEARNING OBJECTIVES After completing this chapter, you will be able to: ● Calculate the net present value (NPV) of a capital investment and use the NPV to decide whether the investment should be made ● Under conditions of capital rationing, choose the best com- bination of investments from a group of acceptable capital investment opportunities ● Select the best investment from two or more mutually exclusive investments ● Calculate the internal rate of return (IRR) of a capital inves
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  chapter LEARNING OBJECTIVES After completing this chapter, youwill be able to: ● Calculate the net present value( NPV  ) of a capital investmentand use the NPV  to decidewhether the investment shouldbe made ● Under conditions of capitalrationing, choose the best com-bination of investments from agroup of acceptable capitalinvestment opportunities ● Select the best investment fromtwo or more mutually exclusiveinvestments ● Calculate the internal rate of return ( IRR  ) of a capital invest-ment and use the IRR  to decidewhether the investment shouldbe made ● Calculate the payback period of acapital investment BusinessInvestmentDecisions CHAPTER OUTLINE 16.1Comparing Business to PersonalInvestment Decisions16.2The Net Present Value of an Investment16.3Comparing Investment Projects16.4Internal Rate of Return16.5Comparing NPV  and IRR Approaches16.6The Payback Period  659 WHAT ANALYSIS SHOULD A BUSINESS undertake for investmentdecisions such as expanding production,adding another productline,or replacing the existing plant or equipment?In this chapter we will study techniques used by managers to makesound financial decisions on capital investments.We will study three criteria widely employed to guide business investmentdecisions.Two ofthem rest on a solid economic foundation.The third is flawed in some respects but,nevertheless,isfrequently used in business—it is important that youunderstand its limitations.Given the long-term nature ofcapital investments,any rigorous analysis must recognize the time value ofmoney.Most ofthe concepts and mathematics you need to evaluatebusiness investments have already been presented in previouschapters.What remains to learn is the terminology and procedures for apply-ing this knowledge in the analysis potential business investments.  16.1 COMPARING BUSINESS TO PERSONAL INVESTMENT DECISIONS The fundamental principles that guide both personal and business investment deci-sions are the same.The Valuation Principle is as relevant to business investments as itis to personal investments.Use ofthe Valuation Principle to determine the fair marketvalue ofan investment requires three steps: 1. Identify or estimate the cash flows expected from the investment.Ifthere are cashoutflows as well as cash inflows in any particular period,estimate the period’sNet cash flow  Cash inflows  Cash outflows 2. Determine the rate ofreturn appropriate for the type ofinvestment. 3. Calculate the sum ofthe present values ofthe net cash flows estimated in Step 1,discounted at the rate ofreturn determined in Step 2.Ifcash flows are actually received as forecast in Step 1,an investor paying theamount calculated in Step 3 will realize the Step 2 rate ofreturn.But a higher  purchaseprice or lower  (than forecast) cash flows will result in a rate ofreturn that is smaller  than the discount rate used in Step 2.On the other hand,a lower  price or higher  cashflows will result in a rate ofreturn greater  than the discount rate.The nature  ofinvestments made by an operating  business differs markedly from thenature ofmost personal investments.Personal investments fall primarily in a limitednumber ofcategories such as Treasury bills,GICs,bonds,and stocks.With the excep-tion ofcommon stocks,there is a considerable degree ofsimilarity among investmentswithin each category.In addition,an individual investor can usually depend on com-petitive bidding in the financial markets to set fair prices for widely traded securities.In these cases,the investor may not explicitly use the Valuation Principle in selectinginvestments.For investments in plant and equipment by a business,the way in which the assetwill be used and the resulting pattern ofcash flows tend to make each investment sit-uation unique.Also,there are likely to be ongoing cash outflows as well as cashinflows associated with a business investment.These factors argue for a morecomprehensive and rigorous approach in business to handle the great variety of investment possibilities.Individual investors and business managers take different perspectives in deter-mining the discount rate used with the Valuation Principle.An individual investorlooks to the financial markets for benchmark rates ofreturn on each category of investment.A business manager takes the view that a capital investment must befinanced by some combination ofdebt and equity financing.Therefore,a businessinvestment project must provide a rate ofreturn at least equal to  the return requiredby the providers ofthe capital.The weighted average rate ofreturn required by afirm’s sources ofdebt and equity financing is called the firm’s cost of capital.  This cost of capital is the discount rate that should be used when applying the Valuation Principle  to a proposed capital investment project.The sum ofthe present values ofthe pro- ject’s future (net) cash flows discounted at the firm’s cost ofcapital represents thevalue ofthe project to the business.The business should not pay more than this value.The same project may be worth more or less to another business primarily because 660 CHAPTER 16  the project’s future cash flows are likely to differ when operated by another business.It could also be the case that different firms would use differing discount rates becauseofdiffering costs ofcapital.There are three possible outcomes ofa comparison between the present value of future net cash flows and the initial capital investment required. 1. Present value of the future cash flows  Initial investment The cash flows willprovide a rate ofreturn (on the initial investment) exactly equal  to the discountrate—the firm’s cost ofcapital.The investment’s net cash flows will be just enoughto repay the invested capital along with the minimum required rate ofreturn.Thisis,therefore,the minimum condition  for acceptance ofa capital investment project. 2. Present value of the future cash flows < Initial investment The project’s net cashflows will not be enough to provide the sources offinancing with their  full  minimumrequired rate ofreturn (on top ofthe return oftheir capital investment).Note thatwe are not necessarily saying that the project or the suppliers ofcapital lose money—we are saying only that the project will not provide the  full  rate ofreturn embodiedin the discount rate.In this case,the investment opportunity should be rejected. 3. Present value of the future cash flows > Initial investment The investment willearn a rate ofreturn greater than the discount rate—more than the minimumneeded to give the suppliers ofcapital their minimum required return (as well astheir capital investment back).The project should be accepted.The preceding discussion can be summarized in the following decision criterion: 661 BUSINESS INVESTMENT DECISIONS The Economic Value That an Investment Adds to a Firm We have seenthat the sources ofinvestment capital receive their required rate ofreturn (the cost of capital) whenPresent value of(net) cash flows  Initial investmentIn this circumstance,the economic value (present value) ofthe future cash flows is thesame as the amount initially spent to buy the investment.Therefore,undertaking thisinvestment does not change the firm’s value.It follows that,in Case 3 ofthe precedinglist,the difference(Present value ofcash flows)  (Initial investment)represents the value immediately added  to the firm when it makes the initial invest-ment.That is,The providers ofdebt financing have no claim on this added value.It belongs entirely to the firm’s owners (the providers ofequity capital). Value addedto the firm    a Present value of thefuture net cash flows b    a Initialinvestment b Investment Decision Criterion Undertake a business investment opportunity if the present value of thefuture net cash flows (discounted at the firm’s cost of capital) is greaterthan or equal to the initial investment.
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