CHAPTE

COMPLEX INVESTMENT DECISIONS

R 11
 LEARNING OBJECTIVES
2

 Show the application of the NPV rule in the choice between

mutually exclusive projects, replacement decisions, projects
with different lives, etc.
 Understand the impact of inflation on mutually exclusive
projects with unequal lives
 Make choice between investments under capital rationing
 Illustrate the use of linear programming under capital
rationing situation
 Complex Investment Problems
3

 How shall choice be made between investments with

different lives?
 Should a firm make investment now, or should it wait
and invest later?
 When should an existing asset be replaced?
 How shall choice be made between investments under
capital rationing?
 Projects with Different Lives
4

 Thechoice between projects which have different lives should be

made by evaluating them for equal periods of time.

 Example: A firm has to choose between two projects X and Y,

which are designed differently, but perform essentially the same
function. Cash flows of projects are in real terms and the real
discount rate is 10 per cent. The present value of costs are shown
below:
 Projects with Different Lives
5

 Project X has 4-year life while Project Y has 2-year

life. Project Y will be replicated to compare it with
Project X. Project Y costs more than project X.
 Annual Equivalent Value
6 (AEV) Method
 The method for handling the choice of the mutually exclusive
projects with different lives, as discussed in last slide, can
become quite cumbersome if the projects’ lives are very long.

 We can calculate the annual equivalent value (AEV) of cash

flows of each project. We shall select the project that has lower
annual equivalent cost.

NPV
AEV 
Annuity factor
 AEV: Example
7

 In the earlier example, the present value of cash flows of X

is Rs 215,100. You can divide Rs 215,100 by a 4-year
present value factor for an annuity of Re 1 at 10 per cent
(3.1699) to obtain AEV. Similarly, AEV for Y can be
calculated. Y is more costly.
NPV
AEVProject X =
Annuity factor
215,100
= = Rs 67,857
3.1699
129, 420
AEVProject Y = = Rs 74,572
1.7355
 AEV for Perpetuities
8

 When we assume that projects can be replicated at

constant scale indefinitely, we imply that an annuity is
paid at the end of every n years starting from the first
period.
 (1  k ) n 
NPV  (NPVn )   
 (1  k ) n
 1 

where NPV¥ is the present value of the investment

indefinitely, NPVn is the present value of the investment
for the original life, n and k is the opportunity cost of
capital.
 Nominal Cash Flows and Annual Equivalent Value
9

 Continue with earlier example. Let us assume expected inflation of

4% . The real cash flows of X and Y can be converted into nominal
cash flow (as shown below) and the real discount rate into nominal
discount rate: (1.04) x(1.10) -1=0.144. Notice that the ranking of
projects changes at higher inflation rate of 15%. Thus, the choice
should be based on real AEV.

Inflation and Annual Equivalent Value

 Investment Timing and
10
Duration
 The rule is straightforward: undertake the project at
that point of time, which maximizes the NPV.
 Tree Harvesting Problem
11

 The maximisation of the investment’s NPV would

depend on when we harvest trees.
 The net future value of trees increases when harvesting
is postponed; but the opportunity cost of capital is
incurred by not realising the value by harvesting the
trees.
 The NPV will be maximised when the trees are
harvested at the point where the percentage increase in
value equals the opportunity cost of capital.
 Tree Harvesting Problem
12

 Suppose the net future value obtained over the years

from harvesting the trees is At and if the opportunity
cost of capital is k, then the net present value (NPV)
of the net realisable value of trees is given by:
 Tree Harvesting Problem
13

 To determine the optimum harvesting time, which maximizes

the NPV, we set the derivative of the NPV with respect to t in
Equation equal to zero.

 Land may have value since the trees can be replanted.

Therefore, the correct formulation of the problem will be to
assume that once the trees are harvested, the land will be
replanted. Thus, if we consider a constant replication of the
tree-harvesting investment indefinitely, then the NPV will:

( At  C)
NPV  C  kt
e 1
 Replacement of an Existing Asset
14

 Replacementdecisions should be governed by the

economics and necessity considerations.

 An equipment or asset should be replaced

whenever a more economic alternative is available.
 Example
15

A company is operating equipment, which is expected to

produce net cash inflows of Rs 4,000, Rs 3,000 and Rs 2,000
respectively for next 3 years. A design, which is considered to
be a technological improvement and more efficient to operate,
has appeared in the market. It is expected that the new
machine will cost Rs 12,000 and will provide net cash inflow
of Rs 6,000 a year for 5 years. What should the company do?
Assume 12 per cent discount rate.
 Example
16

 The correct method of analysis is to compare the annual equivalent value

(AEV) of the old and new equipments as given below.

 A chain of new machines is equivalent to an annuity of Rs 9,630  3.605 =

Rs 2,671 a year for the life of the chain. The existing machine is still
capable of providing an annuity of: Rs 7,390  2.402 = Rs 3,076. So long
as the existing machine generates a cash inflow of more than Rs 2,671
there does not seem to be an economic justification for replacing it.
Investment Decisions Under Capital
Rationing
17

 Capital rationing refers to a situation where the firm is

constrained for external, or self-imposed, reasons to obtain
necessary funds to invest in all investment projects with
positive NPV.
 Under capital rationing, the management has to decide to
obtain that combination of the profitable projects which yields
highest NPV within the available funds.
 Why Capital Rationing?
18

 There are two types of capital rationing:

1. External capital rationing: imposed by capital markets

2. Internal capital rationing: self-imposed by the

company internally
19
Profitability Index
 The objective of the NPV rule under capital constraint should be to
maximise NPV per rupee of capital rather than to maximise NPV.

 Projects should be ranked by their profitability index, and top-

ranked projects should be undertaken until funds are exhausted.

 The Profitability Index does not always work. It fails in two

situations:
 Multi-period capital constraints.
 Project indivisibility.
 Limitations of Profitability Index
20

 Multi-period capital constraints

 Project indivisibility
 Profitability Index: Example
21

 The NPV and profitability index of the following four

projects are shown. Given the budget constraint of Rs 50,
projects M and N will be selected as per PI.
 Programming Approach to Capital
Rationing
22

 Capital rationing presents a situation of maximising net

present value of several projects subject to funds
constraint. Hence, programming approach can be used
for decision making.
 Linear Programming (LP)
 Integer Programming (IP)
 Dual variable
 Example
23

 Let us consider four projects – L, M, N and O, given

earlier. The company has budget constraint of Rs 50
each in year 0 and year 1.

 We need to maximise NPV subject to budget

constraints. Since investments will be positive, we
will put as constraints.
 Example
24

Maximize NPV
NPV = 12.94 X L + 8.12 X M + 7.75 X N + 6.88 X O
Subject to:

The LP Solution of the problem:

 Integer Programming
25

A large number of projects in practice are indivisible. When

projects are not divisible, we can use integer programming
(IP) by limiting the X’s to be integers of either 0 to 1.

 Integer programmes are difficult to solve. It may take

unwieldy number of iterations for the model to converge on a
solution. Also, other restrictions may prove to be redundant on
account of integer restriction.
 Dual Variable
26

 Dual variables for the budget constraints may be interpreted

as ‘opportunity costs’ or ‘shadow prices.’ In the earlier
example, dual variables for the budget constraints in periods 0
and 1 respectively, are 0.344, and 0.086.
 The dual variables of 0.344 for period 0 imply that NPV can
be increased by Rs 0.344 if the budget in period 0 is increased
by Re 1. In other words, the opportunity cost of the budget
constraint for period 0 is 34.4 per cent, and for period 1 it is
8.6 per cent. Dual variables provide information for deciding
the shifting of funds from one period to another.
 Extensions of Programming
27
Approach
 The use of LP or IP models can be extended to
cope with other constraints.

A firm may like to provide for the carry over of

unspent cash from one period to another.

 Inaddition to financial constraints, non-financial

constraints can also be included.
Limits to the Use of Programming
Approach
28

 First, they are costly to use when large, indivisible

projects are involved.

 Second, these models assume that future

investment opportunities are known. The discovery
of investment opportunities in practice is an
unfolding process.
 Capital Rationing in Practice
29

 Capital rationing does not seem to be a serious

problem in practice.

 Itmay arise due to the internal constraint or the

management’s reluctance to raise external funds.

 When companies face the problem of shortage of

funds, they use simple rules of choosing projects
rather than the complicated mathematical models