Chapter 4 Investment Efficiency

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INVESTMENT economics

Part 4: Investment
Efficiency

Slides by Upa Minh-FTU


LEARNING GOALS

- To understand the various indicators of


profitability and return used in performance
evaluation;
- To be able to define and calculate each indicator
for any given project;
- To understand how these indicators affect
performance evaluation and investment decisions.

Slides by Upa Minh-FTU


STRUCTURE
4.1. Definitions
4.2. Measures without time-consideration
- Payback period (PP)
- Break-even point (BEP)
4.3. Measures with time-consideration
- Weighted Average Cost of Capital (WACC)
- Net Present Value (NPV)
- Profitability of Investment (PI)
- Internal rate of Return (IRR)
- Discounted Payback period (DPP)

Slides by Upa Minh-FTU


4.1. Definition
Vu, T. K. O. & Nguyen, T. V.
H, "The efficiency of an
investment activity or a project is
the difference between benefits
and costs."

Slides by Upa Minh-FTU


- Private investors: financial
efficiency
- Society: economic & social
efficiency

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Measures
◼ Measures without time-consideration/
Non-discounted cash flow method
◼ Measures with time-consideration/
Discounted cash flow method

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4.2. Non-discounted cash flow method

4.2.1 Payback period


4.2.2 Break even point

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4.2.1 Payback period (PP)
Vu, T. K. O. and Nguyen, T. V. H, "Payback period of a
project is a duration of time which is just enough for the
total revenue to cover the total investment of the whole
project life cycle."
T n

 i  i
TR =
i =0
TC
i =0

Slides by Upa Minh-FTU


EXERCISE 1 (PP)
0 1 2 3 4 5
Preparation
Fixed asset -30
DWC -10
Execution
Revenue 50 50 50 50 50
Cost (depreciation included) -26 -26 -26 -26 -26
Depreciation 6 6 6 6 6
Tax -6 -6 -6 -6 -6
Difference in DWC 0 0 0 0 0
Closeout
Liquidation 0
Receiving from DWC 10
CF -40 24 24 24 24 34
If equally TR, using below formula:
n
t = C
i =0
i / TRi

Slides by Upa Minh-FTU


PP: time required to recover the initial cost of
investment

Initial cost of Investment


PP =
Annual cash flow

Slides by Upa Minh-FTU


EXERCISE 2 (PP)
Year 0 1 2 3 4 5
Preparation
Fixed asset -60
DWC -20 -5 -5 2.5 2.5
Execution
Revenue 80 100 120 110 100
Cost (depreciation included) -76 -92 -108 -100 -92
Depreciation 12 12 12 12 12
Tax -0.8 -1.6 -2.4 -2 -1.6
Closeout
Liquidation 5
Receiving from DWC 25
Tax from liquidation -1
CF -80 10.2 13.4 24.1 22.5 47.4
If annual cash flow are not the same, using the formula
t
|  CFi |
PP = t + i =0
CFt +1
t: year nearly full recovery

Slides by Upa Minh-FTU


HOW TO USE PP?

• How long it will take for the investment to pay back the
initial cost?
• In project selection
- PP < target payback → accept

- PP > target payback → reject

• In alternative-projects selection
Choose the shortest PP

Slides by Upa Minh-FTU


EXERCISE 3 (PP)

Assume NEM company is deciding between two machines (Machine


A and Machine B) in order to add capacity to its garment plant. The
company estimates the cash flows for each machine to be as follows:
Table3: Expected after-tax cash flows for the new machines
Year 0 1 2 3 4 5
Machine A -5000 500 1000 1000 1500 2500
Machine B -2000 500 1350 1500 1500 1500

Calculate the PP of the two machines using the above cash flows and
decide which new machine NEM should accept. Assume the target
payback period the company establishes is 5 years.
Slides by Upa Minh-FTU
ANSWER 3 (PP)

PP of Machine A = 4 + 1000/2500 = 4.4 years


PP of Machine B = 2 + 150/1500 = 2.1 years

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PP: PROS AND CONS

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4.2.2 Break even point (BEP)
BEP is used to determine the point at which revenue received
equals the costs associated with receiving the revenue.
Vu T. K. O. and Nguyen T. V. H "Break even point is the point at
which total sales is just enough to cover total costs"

TR = TC
PQBEP = FC + VC = FC + vQBEP
FC
FC: fixed cost QBEP =
VC: variable cost
v: variable cost per unit P−v
Slides by Upa Minh-FTU
EXERCISE 1 (BEP)
Assume a company is deciding two options of
buying car for taxi business:
- Plan 1: Buy a new car with total investment
500mVND; v=6000VND/km;
Price=11000VND/km
- Plan 2: Buy a second-hand car with total
investment 240mVND; v=8000VND/km;
Price=11000VND/km
Calculate BEP of the two options and which Plan
that the company should accept
Slides by Upa Minh-FTU
ANSWER 1 (BEP)

 FC 500,000,000 
QBEP1 = P − v = 11000 − 6000 = 100,000 km
 

 FC 240,000,000 
Q = = = 80,000 km 
− −
BEP 2
 P v 11000 8000 

Slides by Upa Minh-FTU


4.3. With time-consideration
4.3.1. Weighted Average Cost of Capital
(WACC)
4.3.2. Net present value (NPV)
4.3.3 Profitability index (PI)
4.3.4. Internal rate of return (IRR)
4.3.5. Discounted Payback period (DPP)

Slides by Upa Minh-FTU


4.3.1. WACC

WACC is used to measure the firm’s cost of capital


in which each category of capital has been
proportionately weighted
WACC = Weight of Equity x Cost of Equity +
Weight of Debt x Cost of Debt

Slides by Upa Minh-FTU


EXERCISE 1 (WACC)

PROJECT: buying a machine


Capital 800m VND, include:
- 400mVND from saving account with rate of 6%/year

- 100mVND from friends with required rate of 14%/year

- 300mVND from bank with interest rate of 16%/year

Calculate WACC of the project.

Slides by Upa Minh-FTU


ANSWER 1 (WACC)

WACC= 400/800x 6% + 100/800 x 14% + 300/800 x 16% = 10.75%

Slides by Upa Minh-FTU


4.3.2. Net present value
A student is considering to study abroad for undergraduate
course during 4 years. Total of enrollment fees 40,000USD
paid in the first year.
After finishing the course, she expects to come back
Vietnam and work for an international company with
salary 400USD/month (=4800USD/year). Also the salary
expected to increase annual 25%.
After working for 6 years, she would quit the job and she
consider Is the investment efficient?
Total of investment: 40,000USD
Total of income:
4,800 + 6,000 + 7,500 + 9,380 + 11,730 + 14,660 = 54,070
USD Slides by Upa Minh-FTU
A dollar today is worth more than a dollar tomorrow.
Slides by Upa Minh-FTU
PRESENT VALUE (PV) AND
FUTURE VALUE (FV)

FVn=PV(1+r)n

1
PV = FVn
(1 + r) n

Slides by Upa Minh-FTU


r=8%/year
YEAR 1 2 3 4 5 6 Total

CASH 4800 6000 7500 9380 11,730 14,660 54,070


FLOWS

PV of CFs 3,267 3,781 4,376 5,068 5,868 6,790 29,150

Slides by Upa Minh-FTU


EXERCISE 1 (PV-FV)

A person puts 100m VND in bank with the different


interest rate:
- 8%/year in the first year and the second year.

- 9%/year during the next 3 years

- 11%/year during the last 4 years

Calculate FV9 and average interest rate.

Slides by Upa Minh-FTU


ANSWER 1 (PV-FV)

FV9=PV (1+r1)2(1+r2)3(1+r3)4
2 3
FV9=100m (1+8%) (1+9%) (1+11%)4

= 100m(1+R) 9

Slides by Upa Minh-FTU


Net present value
Vu, T. K. O. & Nguyen T. V. H.,
”The difference between the
present value of total revenue and
that of total investment; or the
present value of total cash flow
of the project".
Slides by Upa Minh-FTU
n n
1 1
NPV =  TRi −  TC
(1 + r ) i =0 (1 + r )
i i i
i =0

n
1
NPV =  CFi
i =0 (1 + r ) i

Slides by Upa Minh-FTU


NPV

CF1 CF2 CFn


NPV = CF0 + + + ... +
(1 + r ) (1 + r ) 2
(1 + r ) n

CF0: the initial investment


CF1,CF2..,CFn: cash inflow
r: WACC

Slides by Upa Minh-FTU


HOW TO USE NPV?

• Is project profitable?
• In project selection
- NPV>0 → accept

- NPV<0 → reject

• In alternative-projects selection
Choose the biggest NPV

Slides by Upa Minh-FTU


EXERCISE 1 (NPV)

Assume NEM company is deciding between two machines (Machine


A and Machine B) in order to add capacity to its garment plant. The
company estimates the cash flows for each machine to be as follows:
Table3: Expected after-tax cash flows for the new machines
Year 0 1 2 3 4 5
Machine A -5000 500 1000 1000 1500 2500
Machine B -2000 500 1350 1500 1500 1500

Calculate the NPV of the two machines using the above cash flows
and decide which new machine NEM should accept; r=8%

Slides by Upa Minh-FTU


CF1 CF2 CFn
NPV = CF0 + + + ... +
(1 + r ) (1 + r ) 2
(1 + r ) n

NPV(A) = -81.8 < 0


NPV(B) = 2934 > 0

Slides by Upa Minh-FTU


NPV: PROS AND CONS

• Use time value of money


• Use the timing of cash flows
• Target of profit

• Useless to compare with different


scale of projects

Slides by Upa Minh-FTU


EXERCISE 2 (NPV)

Year 0 1 2 3 4

Machine C -100 90 90

Machine D -150 70 70 70 70

Calculate the NPV of the two machines using the above cash flows
and decide which new machine the company should accept; r=8%

Slides by Upa Minh-FTU


ANSWER 2 (NPV)

NPV(C) = 60.5
NPV(D) = 81.8

Slides by Upa Minh-FTU


4.3.3. Profitability index (PI)

Vu, T. K. O. & Nguyen T. V. H.,


”the ratio between the present
value of total revenue and that
of total investment”.

Slides by Upa Minh-FTU


Profitability index
n
1
 TRi
(1 + r ) i
NPV
PI = n
i =0
= 1+ n
1 1
i =0
TCi
(1 + r ) i i =0
TCi
(1 + r ) i

Slides by Upa Minh-FTU


HOW TO USE PI?

• Is project profitable?
• In project selection
- PI>1 → accept

- PI<1 → reject

• In alternative-projects selection
Choose the biggest PI

Slides by Upa Minh-FTU


EXERCISE 1 (PI)

Year 0 1 2 3 4

Machine C -100 90 90

Machine D -150 70 70 70 70

Calculate the PI of the two machines using the above cash flows and
decide which new machine the company should accept; r=8%

Slides by Upa Minh-FTU


PI: PROS AND CONS

• Use time value of money


• Use the timing of cash flows
• Useful to compare with
different scale of projects

• Not determine the profit of project.

Slides by Upa Minh-FTU


4.3.4. Internal rate of return (IRR)

Vu, T. K. O. & Nguyen T. V. H.,


”the rate of return at which total
revenue is equal to total
investment”.

Slides by Upa Minh-FTU


Internal rate of return
n n
1 1
NPV =  TRi −  TCi =0
i =0 (1 + IRR ) i =0
i
(1 + IRR ) i

CF1 CF2 CFn


CF0 + + + ... + = 0
(1 + IRR) (1 + IRR) 2
(1 + IRR) n

Slides by Upa Minh-FTU


EXERCISE 1 (IRR)

Year 0 1 2 3 4

Machine C -100 90 90

Machine D -150 70 70 70 70

Calculate the IRR of the two machines using the above cash flows
and decide which new machine the company should accept

Slides by Upa Minh-FTU


IRR

IRR = r1 + (r2-r1)NPV1/(NPV1+ lNPV2l)

r1: NPV>0
r2: NPV<0
r2-r1 <5% highly recommended

Slides by Upa Minh-FTU


HOW TO USE IRR?

• Is project profitable?
• In project selection
- IRR>r → accept

- IRR<r → reject

• In alternative-projects selection
Choose the biggest IRR

Slides by Upa Minh-FTU


IRR: PROS AND CONS

• Use time value of money


• Use the timing of cash flows
• Without r

• Useless to compare with different


scale and period of projects.

Slides by Upa Minh-FTU


4. Discounted Payback period (DPP)

Vu, T. K. O. & Nguyen T. V. H.,


”the duration that the present
value of total revenue is just
enough to cover that of total
investment”
Slides by Upa Minh-FTU
DPP
T T
1 1

i =0
TRi
(1 + r ) i
= i =0
TC i
(1 + r ) i

t
1
CF0 -  CFi /
(1 + r ) i
DPP = t + i =0
1
CFt +1 t +1
(1 + r )
Slides by Upa Minh-FTU
EXERCISE 1 (DPP)
Year 0 1 2 3 4 5
Machine A -5000 500 1000 1000 1500 2500

Machine B -2000 500 1350 1500 1500 1500

Calculate the DPP of the two machines using the above cash flows
and decide which new machine NEM should accept. Assume the
target payback period the company establishes is 5 years; r=10%

Slides by Upa Minh-FTU


HOW TO USE DPP?

• How long it will take for the investment to pay back the
initial cost?
• In project selection
- DPP < target payback → accept

- DPP > target payback → reject

• In alternative-projects selection
Choose the shortest DPP

Slides by Upa Minh-FTU


DPP: PROS AND CONS

• Use time value of money


• Use the timing of cash flows
• Better than using PP

• Unable to distinguish between the


same DPP of projects
• Not determine the profit of project

Slides by Upa Minh-FTU


Exercise 1 (combi)
Initial
Investment NPV PI IRR DPP

Project A 25 6.08 1.24 18% 6.11

Project B 50 10 1.2 14% 7.024

Project C 25 3.46 1.14 19% 2.12

Choose the best project which meets purpose of investor:


1. Profitabilty
2. Profit ratio
3. Risk management
Slides by Upa Minh-FTU
Exercise 2 (combi)
Projects Initial Investment IRR NPV PI
A 500$ 18% 50$ 1.1
B 5000 25 6500 2.3
C 5000 37 5500 2.1
D 7500 20 5000 1.67
E 12500 26 500 1.04
F 15000 28 21000 2.40
G 17500 19 7500 1.43
H 25000 15 6000 1.24

Choose the best group of projects with the total of


investment 32,500 USD
Slides by Upa Minh-FTU
Answer 2 (combi)

IRR: CFE → Total NPV = 27,000


NPV: FG → Total NPV = 28,500
PI: FBCD → Total NPV = 38,000

Slides by Upa Minh-FTU


Slides by Upa Minh-FTU
Exercise 3 (combi)
- Total estimated investment: 120, in which
+ Fixed asset: 84 (paid all in 1 time in the
preparation pe., equally depreciated in 8 years)
+ The rest is for demanded working capital
- Estimated operation time is 6 years.
- In closeout, fixed assets are liquidated at 22.
- Annual revenue: 120, annual cost (depreciation
included): 105
- Corporate income tax rate: 25%, Min require rate
of return:11%
Slides by Upa Minh-FTU
Exercise 4
1. Set up CF table
2. Calculate financial measures with
time consideration of the project
3. Should the investor carry out this
project?

Slides by Upa Minh-FTU


Exercise 3(combi)
Note:
Operation < Depreciation \
→ the remained value of the fixed
assets
→Tax from:
The remained value - Liquidation

Slides by Upa Minh-FTU


EXERCISE 3 (COMBI)
Year 0 1 2 3 4 5 6
Preparation
Fixed asset
DWC
Execution
Revenue
Cost (depreciation
included)
Depreciation
Tax
Closeout
Liquidation
Receiving from DWC
Tax from liquidation
CF Slides by Upa Minh-FTU
EXERCISE 3 (COMBI)
Year 0 1 2 3 4 5 6
Preparation
Fixed asset -84
DWC -36
Execution
Revenue 120 120 120 120 120 120
Cost (depreciation -105 -105 -105 -105 -105 -105
included)
Depreciation 10.5 10.5 10.5 10.5 10.5 10.5
Tax -3.75 -3.75 -3.75 -3.75 -3.75 -3.75
Closeout
Liquidation 22
Receiving from DWC 36
Tax from liquidation -0.25
CF -120Slides 21.75
by Upa Minh-FTU
21.75 21.75 21.75 21.75 77.5
ANSWER 3 (COMBI)

NPV=1.82
PI=1.01
IRR=11.43%
PP=5.14 years
DPP=5.95 years

Slides by Upa Minh-FTU


EXERCISE 4 (COMBI)

Choose the best project, r=10%


Year 0 1 2 3 4 5 6 7 8

Project A -1000 505 505 505

Project B -10,000 2000 2000 2000 2000 2000 2000 2000 12000

Project C -11,000 2650 2650 2650 702650 2650 2650 2650 2650

Slides by Upa Minh-FTU


ANSWER 4 (COMBI)
Year II NPV PI IRR DPP

Project A -1,000 255.86 1.26 24.04% 2.33

Project B -10,000 5,334 1.53 20% 7.05

Machine D -11,000 3,137 1.29 17.43% 5.64

Slides by Upa Minh-FTU


RANKING PROJECTS

Year II NPV PI IRR DPP Score

Project A -1,000 255.86 1.26 24.04% 2.33 (1) 8


(3) (3) (1)
Project B -10,000 5,334 1.53 20% 7.05 (3) 7
(1) (1) (2)
Machine D -11,000 3,137 1.29 17.43% 5.64 (2) 9
(2) (2) (3)

Slides by Upa Minh-FTU


Year II NPV PI IRR DPP

Project A -1,000 3 3 1 1

Project B -10,000 1 1 2 3

Machine D -11,000 2 2 3 2

Slides by Upa Minh-FTU


EXERCISE 5

Year 0 1 2 3

Project M -120 100 25 25

Project N -110 25 25 100

1) Compute NPV, r=10%


2) Calculate r1 that at which NPV(M) = NPV(N)

Slides by Upa Minh-FTU

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