AFM- Discounted Cash Flow

Techniques
Contents
Application of Discounted Free Cash Flow to the Appraisal of Investment Projects ............ 2
FREE CASH FLOWS: ............................................................................................................. 2
The Impact of Inflation on Project Free Cash Flows .............................................................. 6
The Impact of Tax on the Computation of Project Free Cash Flows.................................... 11
The Internal Rate of Return.................................................................................................. 15
INTERNAL RATE OF RETURN: ............................................................................................ 15
MODIFIED INTERNAL RATE OF RETURN: .......................................................................... 17
Sensitivity Analysis of an Investment Project ...................................................................... 20
Investment Project Duration ................................................................................................ 24
Monte Carlo Simulations in Investment Appraisal .............................................................. 28
SIMULATION: .................................................................................................................... 28
THE MONTE CARLO SIMULATIONS: .................................................................................. 28
CAPITAL RATIONING:............................................................................................................ 30
APPROACHES TO CAPITAL RATIONING:............................................................................ 30
Revision ................................................................................................................................ 35
International Investment- Dec 2013 Q1 - Chumra ........................................................... 35

1
Application of Discounted Free Cash Flow to the Appraisal
of Investment Projects
FREE CASH FLOWS:

Free cash flows are the cash accumulated by a company may either be paid out to
shareholders as a dividend, or may be used internally, to finance investment opportunities.
Free cash flow may be calculated as the company’s revenue, from which costs and amounts
necessary for investments have been subtracted. The concept of free cash flow is widely
used across finance, for example as a measure of a company’s profitability or as an input
into company valuation. The basic idea behind such valuation involves computing the
present value of the free cash flows generated by the investment, using relevant discount
factors.

There are several investment valuation methods which are based on the discounting of cash
flows. The most widely used is net present value (NPV). As you already know, computing
NPV involves discounting the net cash flows associated with an investment, using discount
factors reflecting the company’s cost of capital.

Discounting:

Discounting is the process of determining the present value of a future payment or a stream
of future payments. Typically, a future payment is worth less in today’s money than it will be
worth at the time when it becomes due. This difference is referred to as the time value of
money and is reflected by the rate of interest.

Let us now review the basic formulas used in discounting. Discounting is a mathematical
operation which may be thought of as being the opposite of compounding, which is the
calculation of the future value of a cash flow. Future value (FV), also called terminal value, is
computed as today’s value of a cash flow (CF), multiplied by the exponential compounding
factor expressed as 1 plus the relevant annual interest rate, raised to a power corresponding
to the number of annual periods, in which the payment will actually be made or received:

FV = CF(1 + r)n

The basic discounting formula is; the present value of a future cash flow equals the size of
that cash flow, divided by a factor which is calculated in exactly the same way as in the case
of compounding:

2
PV = CF
(1 + r)n

Mathematically, this formula may also be transformed in such a way, that the present value
of a future cash flow is given as its size multiplied by a term equal to one plus the interest
rate, raised to a power of minus the number of annual periods. This term is specifically
referred to as the discount factor:

PV = CF(1 + r)n

For example, if we need to compute the present value of $100 dollars receivable or payable
in 3 years’ time, and

the annual interest rate equals 5%, we will obtain the present value by:

PV = $100(1 + 0.05)3 = $100(0.864) = $86.40

Present value tables:

You should be aware that discounting may be performed with the aid of so-called present
value tables. Typically, a present value table takes the form of a matrix, where the first row
contains annualised interest rates, and the first column presents the number of periods. The
matrix is populated with discount factors, and in order to find the required factor, all that
needs to be done is to find the intersection of the relevant rate and the number of periods.
Let’s now use the discount table to see if we calculated the 5% 3-year discount factor
correctly. To do that we have to find the column containing the discount factors computed
at a rate of 5%, and then locate its intersection with the 3-year row. As you can see, the
number at the intersection is 0.864, which is the same as the factor previously calculated
manually:

Period (n) Interest rate (r)

1% 2% 3% 4% 5%
1 0.99 0.98 0.971 0.962 0.952
2 0.98 0.961 0.943 0.925 0.907
3 0.971 0.942 0.915 0.889 0.864
4 0.961 0.924 0.888 0.855 0.823
5 0.951 0.906 0.863 0.822 0.784

Annuity:

The discounting formula which we have just presented, allows for the computation of the
present value of a single future payment or a series of such payments. As you can imagine,
in the case of a series, computing present value requires repeating the calculation several
times in a row. For example, if a series includes 10 future cash flows, then we will have to
3
separately derive 10 discount factors for the respective future periods of time, when those
cash flows will be taking place.

However, a formula exists, which allows for the calculation of the present value of a series
of identical future annual payments of the same amount in one step. Such a series is
referred to as an annuity and the present value of an annuity equals the annuity amount,
that is the level cash flow which gets repeated, multiplied by an annuity factor (AF),
expressed as 1 less 1 plus the annual interest rate, raised to the power of minus n, which
corresponds to the number of annual payments multiplied by minus 1, and divided by the
rate of interest:

AF = 1  (1 + r)n/ r

PV of annuity = CF × AF

Let’s inspect an example. Imagine an annuity comprising two cash flows of €200 each,
where the annual interest rate is 5%. Let us begin by calculating the relevant annuity factor:

So, the present value of the annuity will amount to:

PV of annuity = €200 × 1.859 = €371.80

Let’s now check if applying the annuity factor generates the same result as calculating the
present value of the individual cash flows which comprise the annuity. When we inspect the
present value table, we find that the one-year discount factor at the rate of 5% is 0.952, so
the present value of a €200 cash flow falling in one year’s time amounts to:

PV =€200(1 + 0.05)1 = €200 × 0.952 = €190.40

The two-year 5% discount factor equals 0.907, and so, the present value of a cash flow of
€200 euro falling in two years’ time is:

PV =€200(1 + 0.05)2 = €200 × 0.907 = €181.40

Adding the two numbers together, we, once again, arrive at:

Total PV = €190.40 + €181.40 = €371.40

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Annuity table:

Instead of explicitly calculating annuity factors, they may be found in an annuity table, which
is used in a similar way as the present value table. To find the required annuity factor, we
need to identify the relevant interest rate in the first row of the matrix and the number of
payments comprising the annuity in the first column. The annuity factor will naturally be
found at the intersection of the relevant row and column. Accordingly, to locate the annuity
factor from our example we need to check the intersection of the 5% interest rate and two
periods. As you can see, the factor found in the matrix is 1.859 and is identical to the one
which we just calculated manually:

Period (n) Interest rate (r)

1% 2% 3% 4% 5%
1 0.99 0.98 0.971 0.962 0.952
2 1.97 1.942 1.913 1.886 1.859
3 2.941 2.884 2.829 2.775 2.723
4 3.902 3.808 3.717 3.36 3.546
5 4.853 4.713 4.58 4.452 4.329

Perpetuity:

A specific type of annuity is referred to as a perpetuity, and involves an infinite series of

identical, level cash flows. As you can surely appreciate, it would be impossible to calculate
all of the discount factors necessary to obtain the present value of such a cash flow stream,
simply because their number is also infinite. You may have noticed, however, that discount
factors become progressively lower as we increase the number of periods, in which they are
expected to be made or received. So, the discount factors in respect of periods which are far
away, actually converge to zero. It may mathematically be proven that for an infinite
number of payments, the present value of an annuity is in fact given by the size of the
annual, perpetual cash flow, divided by the annual rate of interest:

PV of perpetuity = CF/ r

For example, if the annual payment in a perpetuity is $100 dollars and the interest rate is
10%, the present value of the perpetuity equals $1,000:

PV of perpetuity = $100/ 0.1 = $1,000

NOTE: Discounting is a widely used method of calculating the present value of future cash
flows, applied not only to the evaluation of investments, but also in the valuation of
companies. In the context of appraising investment projects, discounting techniques are
applied to calculate the net present value of a project, using the cost of capital to derive the
relevant discount factors.

5
The Impact of Inflation on Project Free Cash Flows
INFLATION AND INVESTMENT APPRAISAL:

Investment projects are evaluated by calculating the net present value (NPV) of free cash
flows which are expected to be generated from those projects, using discount factors
reflecting the investor’s cost of capital. If the NPV of the project is positive, then it is worth
investing in. It is important to add that the free cash flows of an investment project should
be adjusted for the effect of inflation.

Inflation:

As you know, inflation is the change in the level of prices. Typically, inflation is a positive
figure, implying that prices of goods and services grow over time. Negative inflation, called
deflation, reflects a decrease in price levels. So, inflation results in a decline in the value of
money, whereas deflation is associated with an increase in the value of money.

With the value of money typically declining, the nominal return generated on an investment
consists of two components:

– The real return

– Compensation for the effect of inflation

You should be aware, that various types of inflation rates are actually used in economic
analysis:

 To start with, there is the so-called general inflation, which reflects the average
change in price levels in the economy.

 Furthermore there are also specific inflation indices, relating to individual types
of goods, services and sectors, for example wages or oil and gas products.

Fisher equation:

The relationship between the nominal return, the real return and inflation can be
mathematically presented in

the following way:

(1 + i) = (1 + r)(1 + h)

Where:

i = Nominal return

r = Real return

h = Inflation

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Impact of inflation on free cash flows:

As we already said, the impact of inflation should be included in the calculation of an

investment project’s NPV.

There are, in fact, two methods of doing this:

1. Method involving the application of nominal rates of return:

Incorporation of more specific inflation rates into the NVP computation requires application
of the nominal method, under which all project cash flows are adjusted using specific
inflation rates pertaining to those cash flows, and the free cash flows of the project are
subsequently discounted using the nominal rate of interest.

2. Method based on real rates of return:

Under the so-called real method, project cash flows are not inflated, and instead, are
discounted using real interest rates, or interest rates from which the impact of inflation has
been removed. As you can see, under the real method, incorporating inflation into the NPV
calculation is achieved purely by adjusting the discount factors. Consequently, this method
is typically applied when only the general rate of inflation is known.

EXAMPLE:

Let’s illustrate the nominal method with an example. A company is considering an

investment project, which is expected to result in an annual increase of the company’s
revenues, amounting to €3 million over the two following years. Entering into the project
requires an initial investment of €4 million which is to be made upfront. Additionally, the
company expects that as a result of the project, the level of wages will increase by €0.5
million annually, and that the project will require an additional investment in working
capital at the beginning of each year, amounting to 15% of the increase in revenue. What is
more, the following forecasts are available regarding the level of inflation over the next two
years. General inflation is expected to amount to 7% annually, and specific inflation rates
relating to revenues and wages are expected to equal 12% and 5%, respectively. Let’s
analyse if the project is worth undertaking, assuming that the real cost of capital in the
company amounts to 6%.

To evaluate the project, we need to calculate the net present value of the free cash flows
expected to be generated from it, which amount to the project’s revenues reduced by its
costs. In the analysed example, the latter include the initial investment, increase in wages as
well as the required working capital injections. Because specific inflation rates are available,
we will use the nominal method.

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Let’s first calculate the operating cash flows of the project:

We know that in each of the two years the revenues from the investment will amount to €3
million in real terms and that the specific inflation rate relating to revenue is 12% per
annum.

So, after the first year, revenue will amount to: €3 million x 1.12 = €3.36 million.
In year two, the revenue will equal: €3 million x 1.12 2 = €3.763 million.

In the next step, we will calculate the impact of the anticipated wage increase. We know
that investing in the project will trigger a jump in wages of €0.5 million annually and that
wage-specific annual inflation is expected to equal 5% per year.

So, in year 1, the adjusted wage expense will amount to: €0.5 million x 1.05 = €525K.

In year two, we need to account for 2-year inflation factor, which amounts to: €0.5 million
x 1.052 = €551K.

Having calculated the revenues and wages, we can compute the operating cash flows of the
project:

Year 0 Year 1 Year 2

Initial investment €’000

(4,000) €’000 €’000
Revenue 3,360 3,763
Wages (525) (551)
Operating CF (4,000) 2,835 3,212

Please note that the operating cash flows of the project have to be additionally adjusted by
the required injection of working capital:

We know that working capital needs to be increased in advance and that this increase
amounts to 15% of the hike in revenues. Accordingly, at the beginning of year 1 the
company will need to spend 15% of its entire year 1 revenue of €3.36 million, that is (3.36
million x 15% =) €504 thousand, and this amount will have to be included in the calculation
of the cash flows associated with the project.

At the beginning of year 2, working capital will have to be raised to a level corresponding to
15% of the adjusted revenue of €3.763 million, which is (3.763 million x 15% =) €564
thousand. The increase in working capital at the beginning of year 2 will therefore equal
(564,000 – 504,000 =) €60 thousand, which should, once again, be included in the
calculation of project cash flows.

8
Now that we have derived all of the cash flow components of the project, we may proceed
with the calculation of free cash flows:

Year 0 Year 1 Year 2

Initial investment (4,000)

€1000 €1000 €1000
Revenue 3,360 3,763
Wages (525) (551)
Operating CF (4,000) 2,835 3,212
Working capital injection (504) (60) -
Free cash flow (4,504) 2,775 3,212

In order to calculate the NPV of the cash flows which we have just laid out, we need to
discount them using the company’s cost of capital:

We know that the real cost of capital is 6% per annum. Please recall, however, that we are
using free cash flows of the project adjusted for inflation. So, in order to maintain
consistency of the calculations, the cost of capital should also be inflated. We know that the
general inflation rate amounts to 7%. We also know the formula for adjusting real rates for
the effects of inflation.

So, in order to calculate the nominal cost of capital, we have to multiply the sum of 1 and
the real cost of capital by the sum of 1 and the general inflation rate, and subtract 1 from
the result:

Nominal rate = Real rate × Inflation

(1 + i) = (1 + r)(1 + h)
(1 + i) = (1 + 6%)(1 + 7%)
(1 + i) = (1.06)(1.07)
(1 + i)  1.13
i  1.13  1  0.13  13%

We may now proceed to calculate the relevant discount factors:

We will need both a 1-year and 2-year discount factor computed in respect of 13%. Using
the present value table we discover that the 1-year factor is 0.885, whereas the 2-year
discount factor amounts to 0.783.

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Multiplying the free cash flows by the discount factors, we receive the following present
values:

Year 0 Year 1 Year 2

Initial investment (4,000)

€1000 €1000 €1000
Revenue 3,360 3,763
Wages (525) (551)
Operating CF (4,000) 2,835 3,212
Working capital injection (504) (60) -
Free cash flow (4,504) 2,775 3,212
Discount factor (@ 13%) 1 0.885 0.783
PV of free cash flow (4,504) 2,456 2,515

When we sum these results and include the initial outflow of €4.504 million, we arrive at the
net present value of the project of: NPV = (€4.504 million) + €2.456 million + €2.515 million
= €467,000

The NPV of the project including inflation is thus positive, which means that it is
worthwhile for the company to take the project on.

As you can see, discounted cash flow techniques allow for the computation of the free cash
flows from an investment, and may also accommodate adjustments in respect of inflation.

10
The Impact of Tax on the Computation of Project Free Cash
Flows
RULES:

Taxation may affect an investment opportunity in two ways:

1. The first of these is the imposition of taxes on operating cash flows

2. The second relates to the tax deductibility of asset depreciation

In investment appraisal, it is typically assumed that:

– Operating cash inflows are subject to taxation at the corporate income tax rate.

– The operating outflows associated with a project are tax deductible.

– Tax is paid in the same year in which the relevant cash flows are actually
generated.

When it comes to the tax consequences of asset depreciation, it should be noted that the
rate of depreciation applied for income tax purposes may differ from the rate used for
financial reporting purposes. Furthermore, tax laws may differ in this respect across
jurisdictions. Nevertheless, there typically exists a certain level of tax allowable depreciation
(TAD), which ought to be incorporated into the tax calculation. As we already mentioned,
the detailed regulation of tax deductible allowances may differ across jurisdictions. In the
United Kingdom, the rules on TAD are such that it should be:

 Calculated under the reducing balance approach

 The total amount of TAD for an asset ought to be equal to the cost of its
acquisition less the value at which it is disposed of

TAD is allowable in each year in which an asset is in use, except for the year of its disposal.
Consequently, in the year when an asset is sold or scrapped, there is a left over allowance
equal to the difference between the asset’s written down value and the amount for which it
is sold.

EXAMPLE:

Let’s analyse an example to illustrate how taxation impacts the calculation of free cash flows
and the net present value of an investment project. Let us assume that a company is
purchasing an asset for €20,000, and that the asset will be used over the subsequent 3
years. Furthermore, the asset is expected to generate revenue of €9,000 in each year. The
rate of corporate income tax is 40% and tax allowable depreciation amounts to 30%, and is
calculated on a reducing balance basis. On the last day of year 3, the company will sell the

11
asset for €7,500. The relevant cost of capital is 5%. So, let’s calculate the NPV of the
investment to see if it should be taken on.

As we already mentioned, when evaluating an investment, we will apply the corporate

income tax rate to the operating cash inflows of the project and adjust the result for the
positive effect of tax allowable depreciation.

Let us first calculate the TAD, which will be deducted throughout the 3 years of the
project:

The initial value of the asset is €20,000, and allowable depreciation ought to be computed at
a rate of 30%. Accordingly, in the first year, the company will be able to make a deduction of
(20,000 x 30% =) €6,000.

In the second year, it will deduct 30% of the reduced balance of the asset, that is (20,000 –
6,000 =) €14,000. Thus, tax allowable depreciation in respect of year two will amount to
(14,000 x 30% =) €4,200.

In year 3, the reduced balance of the asset will equal (14,000 – 4,200 =) €9,800 and in that
same year, the asset will be sold for anticipated proceeds of €7,500. Consequently, the year
3 deductible allowance will correspond to the difference between the asset’s written down
value and the disposal proceeds, that is an amount equal to (9,800 – 7,500 =) €2,300.

So, the tax allowable depreciation across the three years of the project will comprise:

Year Opening balance (€) Tax @ 30% (€) Closing balance (€) Sale proceeds (€) TAD (€)
1 20,000 6,000 14,000 N/A 6,000
2 14,000 4,200 9,800 N/A 4,200
3 9,800 N/A (year of sale) 9,800 7,500 2,300

Let us now calculate the free cash flows of the project:

– At time zero, the only relevant cash flow is the €20,000 investment in the asset.

– In year 1, the company will record revenue of €9,000. As we already pointed out,
operating cash inflows are subject to taxation at the corporate income tax rate,
so we need to deduct a tax charge equal to 40% of €9,000, which is (9,000 x 40%
=) €3,600.

Next, we need to adjust the tax burden by the tax relief associated with allowable
depreciation. The year 1 TAD is €6,000, so the corresponding tax relief will amount to:
€6,000 x 40% = €2,400.

The free cash flow computed in respect of the first year is therefore equal to: €9,000
(revenue) – €3,600 (tax) + €2,400 (tax saving) = €7,800.

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  In year 2, the tax on revenue is a further €3,600, and that is because the level of
revenue does not change. As we have already calculated, tax allowable
depreciation in respect of year 2 equals €4,200, so the tax saving associated with
depreciation may be computed as: €4,200 x 40% = €1,680.

Consequently, the free cash flow in respect of year 2 equals: €9,000 (revenue) –
€3,600 (tax) + €1,680 (tax saving) = €7,080.

– In the final year, the asset is sold, and the balancing TAD allowance comes in at
€2,300.

The tax saving associated with depreciation is thus (2,300 x 40% =) €920.
Accordingly, free cash flow is computed as: €9,000 (revenue) – €3,600 (tax) + €920
(tax saving) + €7,500 (proceeds from the asset disposal) = €13,820.

Year 0 (€) 1 (€) 2 (€) 3 (€)

Initial investment (20,000)
Revenue 9,000 9 000 9 000
Tax on operating cash flows (40%) (3,600) (3 600) (3 600)
Tax saving on depreciation 2,400 1,680 920
Cash flows after tax 7,800 7,080 6,320
Asset disposal 7,500
Free cash flow (20,000) 7,800 7,080 13,820

Having established the free cash flows from the project, we may now calculate the net
present value of the investment. First, we need to identify the discount factors reflecting the
5% cost of capital. Looking these up in the present value table, we find that the 1-year
discount factor amounts is 0.952, the 2-year discount factor is 0.907 and the 3-year factor is
0.864.

So, the discounted cash flows from the investment are as follows:

Year 0 (€) 1 (€) 2 (€) 3 (€)

Initial investment (20,000)
Revenue 9,000 9 000 9 000
Tax on operating cash flows (40%) (3,600) (3 600) (3 600)
Tax saving on depreciation 2,400 1,680 920
Cash flows after tax 7,800 7,080 6,320
Asset disposal 7,500
Free cash flow (20,000) 7,800 7,080 13,820
Discount factor (5%) 1 0.952 0.907 0.864
Present value (20,000) 7,426 6,422 11,940

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When we add the discounted free cash flows and deduct the €20,000 of initial investment,
we arrive at a net present value of: (€7,426 + €6,422 + €11,940) – €20,000 = €5,788. As you
can see, the project has a positive NPV and should therefore be taken on by the company.

14
The Internal Rate of Return
INTERNAL RATE OF RETURN:

As you may recall from previous studies, the internal rate of return of an investment,
abbreviated as the IRR, is a discount rate at which the investment’s net present value equals
zero. Accordingly, if the IRR is greater than the cost of capital, then the project must have a
positive NPV and ought to be accepted. That is because, if the project’s NPV amounts to
zero when the IRR is used as the discount factor, then using a lower discount rate will surely
generate a positive NPV.

The problem with the internal rate of return, however, is that it cannot be computed using a
simple formula. It may, nevertheless, be linearly approximated as a value which lies
between two discount rates, one that is higher, and the second which is lower than the
actual IRR. The formula for performing the approximation is as follows:

Where:

IRR = Internal rate of return

RL = Lower discount rate

RH = Higher discount rate

NPVL = Net present value calculated at lower discount rate

NPVH = Net present value calculated at higher discount rate

You should be aware that the internal rate of return is not a perfect evaluation tool:

 First of all, the IRR cannot be interpreted as the true rate of return on an investment.
That is because the logic of IRR computation assumes that all of the interim cash
flows generated from the project must be reinvested at a rate identical to the IRR,
which is not the necessarily the case in reality.

 What is more, it is possible for a single investment to have multiple IRRs. That’s
because from a mathematical viewpoint, the IRR constitutes the solution to a
polynomial equation. If the stream of cash flows associated with an investment
changes sign only once, for example there is only one negative cash flow at inception
of the project, whereas the net cash flows for all subsequent periods are, in fact,
positive, then the equation will have just one solution. However, if the cash flow
stream changes sign more than once, then there will also be more than one solution

15
 to the polynomial, and so the investment may exhibit multiple internal rates of
return.

Example:

Let’s look at an example of the IRR approximation. Assume that a project requires an
upfront investment equal to $1,800, which will bring a net cash inflow of $1,000 in one year
and a further $1,000 in second year. We will first calculate the project’s NPV assuming that
the cost of financing amounts to 4% annually, and will then proceed to approximate the
project’s IRR.

In order to compute the NPV, we have to use the appropriate1-year and 2-year discount
factors derived in respect of the 4% cost of capital. As you know, we may obtain them from
the present value table. The factors amount to 0.962 and 0.925. So, the present value of the
future cash flows receivable in one year and in two years amount to:

Year 1: $1,000 x 0.962 = $962

Year 2: $1,000 x 0.925 = $925

The sum of these present values is (962 + 925 =) $1,887, which is (1,884 – 1,800 =) $87
higher than the amount of the initial investment. Accordingly, we conclude that at a cost of
capital equal to 4%, the project’s NPV is positive.

As we already said, the IRR is the discount rate, at which the NPV of a project equals zero. In
the analysed case the NPV is positive, which means that the true IRR must, in fact, be higher
than 4%. Let’s, therefore, attempt to approximate the IRR, by applying the formula
introduced a moment ago and using 8% as the higher discount rate. As you may remember,
the IRR approximation makes use of NPVs calculated at the higher rate and at the lower
rate. Thus, we must calculate the NVP at the rate of 8%.

To do that, we need to identify the 1-year and 2-year 8% discount factors, which equal 0.926
and 0.857 respectively. The present value of the cash flows are:

Year 1: $1,000 x 0.926 = $926 dollars

Year 2: $1,000 x 0.857 = $857 dollars

Thus the NPV of the project amounts to: ($926 + $857) – $1,800 = ($17)

We may therefore conclude that the IRR of the project is a rate between 4%, for which the
NPV was positive, and 8%, for which the NPV came in below zero.

Applying the approximation formula, we find that the IRR amounts to the lower rate, that’s
4%, plus the NPV calculated at the 4% discount rate, that is $87, divided by $104, the
difference between the NPV of +$87 and the NVP of –$17, multiplied by the difference
between the two rates. After solving the equation, we arrive at an IRR of:

16
As we have already said, the IRR may be applied to evaluate investment projects, which is
done by comparing it with the cost of capital used. Such comparisons provide additional
information regarding the sensitivity of the project to changes in the cost of capital. The
narrower the difference between the IRR and the cost of capital, the more sensitive and,
therefore, more risky the project becomes.

MODIFIED INTERNAL RATE OF RETURN:

Let us now proceed to discuss an alternative return measure, namely the modified internal
rate of return. The MIRR, as it is commonly referred to, is a more useful measure of
investment performance, because it is unique, in the sense that a specific investment may
only have one MIRR, and because it provides more realistic information on the rate of
return generated by the project.

When the MIRR is used to asses an investment, it is also compared with the cost of capital.
The investment should be accepted when MIRR, representing the project’s return, is higher
than the cost of financing used. In contrast to the IRR, the logic of modified IRR computation
assumes that the positive cash flows generated from a project are reinvested at an assumed
reinvested rate, which is typically lower than the company’s cost of capital, instead of the
IRR.

– The calculation of modified IRR involves dividing the project into the “investment
phase”, in which net cash flows are negative and the “return phase” in which net
cash flows are positive.

– Next, we need to find the terminal or future value of the cash inflows generated by
the project, and the present value of all cash outflows.

The MIRR may then be computed as the nth root of the ratio of the terminal value of inflows
and the present value of outflows minus one:

Where:

n = Overall duration of the project.

17
Example:

Let’s illustrate the calculation of MIRR with an example. An investment considered by a

company requires an initial outlay of $100 dollars at time zero. In years 1 and 3, the
investment will generate inflows of $55 and $100, respectively. An additional investment of
$15 dollars will, however, be required in year 2. The relevant cost of capital is 10%, whereas,
the rate at which the cash flows generated from the project may be reinvested amounts to
8%.

To derive the modified IRR, we first need to compute the present value of the project’s
cash outflows, discounted at a rate equal to the cost of capital. The project features two
outflows:

PV of 1st outflow:

In year 0 = $100 (the present value of the first outflow is obviously equal to its nominal
value, i.e. $100).

PV of 2nd outflow:

In year 2 = $15, the present value of the second outflow requires application of the 2-year
10% discount factor,

which equals 0.826, giving a present value of: $15 x 0.826 = $12.39.

So, the present value of all outflows associated with the investment comes in at (100 +
12.39 =) $112.39.

Let’s now shift our attention to the terminal value of the cash inflows, calculated at the
reinvestment rate, that is values expressed in terms of year 3 money:

The project features two inflows:

FV of 1st inflow:

Year 1 = $55, the year 1 cash flow needs to be rolled forward with the aid of a compounding
factor equal to 1 plus the reinvestment rate of 8%, raised to the power of 2. Thus, producing
a terminal value of: $55 x 1.082 = $64.35.

FV of 2nd inflow:

Year 3 = $100, the terminal value of the cash flow falling in year 3 is equal to its nominal
value.

Thus, the future value of all cash inflows from the project equals (100 + 64.35 =) $164.35.

Finally, in order to calculate the actual MIRR, we need to compute the third root of 164.35
over 112.39, and subtract one.

18
The result is a modified internal rate of return of 13.5%. As you can see, the rate is higher
than the cost of capital used, and so, the project should be approved.

19
Sensitivity Analysis of an Investment Project
SENSITIVITY ANALYSIS:

Sensitivity analysis involves measuring the impact of a change in a given variable on net
present value. In particular, sensitivity analysis may be applied to determine the magnitude
of change in a given variable, which would trigger a fall in net present value to zero,
rendering an investment project unprofitable. A simple formula to calculate the sensitivity
of NPV to changes in a given variable involves computing the ratio of the project’s NPV and
the present value of those cash flows which are affected by the variable. The ratio
multiplied by 100% provides a percentage measure of NPV sensitivity.

Sensitivity =NPV/ PV of variables

Example:

Let’s now turn our attention to an example, in which we will get an opportunity to inspect
the sensitivity of an investment project’s NPV to the level of revenues, costs and tax rates.
Assume that an investment requires an initial capital outlay of £6,000 pounds. In each of the
subsequent 3 years, revenue from the investment is expected to equal £3,500. The annual
level of operating expenses expected to be incurred in association with the investment
amounts to £500. Let us further assume that the rate of income tax is 20% and that the
relevant cost of capital equals 9%. The annual tax relief due to the depreciation of assets is
£50. Let’s calculate the project’s NPV and then analyse how sensitive it is to changes in the
level of revenues, costs and tax rates.

As the first step we need to compute the annual free cash flows generated by the
investment:

In this project, the cash flows in all three years are identical. We may therefore calculate the
annual net operating

cash flow, amounting to: £3,500 revenue – £500 costs = £3,000.

Next, we must subtract the tax charge, which is calculated as the corporate income tax rate
of 20% multiplied by the net operating cash flow, giving (3,000 x 20% =) £600 per annum.

20
Finally, we need to take note of the £50 of tax relief resulting from tax allowable
depreciation. Consequently, the free cash flows in years 1, 2 and 3 amount to:

Year 0 (£) 1 (£) 2 (£) 3 (£)

Capital expenditure (6,000)
Revenue 3,500 3,500 3,500
Cost (500) (500) (500)
Operating CF 3,000 3,000 3,000
Tax @ 20% (600) (600) (600)
Depreciation tax saving 50 50 50
Free Cash Flow (6,000) 2,450 2,450 2,450

In order to obtain the net present value of the project we need to add the stream of
discounted payments, consisting of the initial investment of £6,000 year zero, and the three
cash inflows of £2,450 in years 1, 2, and 3. Treating the level inflows as a 3-year annuity and
applying the relevant 9% annuity factor of 2.531, we arrive at a net present value equal to
approximately £201:

Year 0 (£) 1 (£) 2 (£) 3 (£)

Capital expenditure -6,000
Revenue 3,500 3,500 3,500
Cost -500 -500 -500
Operating CF 3,000 3,000 3,000
Tax @ 20% -600 -600 -600
Depreciation tax saving 50 50 50
Free Cash Flow -6,000 2,450 2,450 2,450
Discount factor @ 9% 0.917 0.842 0.772
PV -6,000 2,247 2,063 1,891
NPV = (2,247 + 2,063 + 1,891)– 6,000 = 201

As you can see, the NPV is positive and so the company should generally choose to go ahead
with the investment.

Let’s see how sensitive the value of the project is to the key factors:

As you already know, in order to calculate the sensitivity measure, we need to divide the
NPV of the project by the present value of the cash flows affected by the variable, whose
sensitivity we want to explore. In this case these are:

1. Revenues:

Let’s first calculate the project’s sensitivity to the level of revenues. To do that, we need to
compute the overall present value of the revenue stream. Revenue contributes to the
project’s NPV by an amount adjusted for the effect of income tax.

21
Consequently, we will make use of after tax revenues, amounting to: £3,500 x (1 – 20%) =
£2,800.

The stream of after-tax revenues constitutes a 3-year annuity payment, and in order to find
its present value we may use the annuity table. The 3-year annuity factor under the 9% rate
of interest equals 2.531.

So, the present value of the revenue annuity amounts to (2,800 x 2.531 =) £7,087. We may
now proceed to compute the sensitivity ratio, which is given as:

This has the following interpretation:

If revenues generated from the investment were to drop by 2.84% relative to the planned
level, the project’s net present value would fall to zero, making the investment unprofitable
at a cost of capital equal to 9%. We may therefore conclude that despite the positive NPV,
the project is relatively risky, especially if there is uncertainty regarding the level of future
revenues.

2. Costs:

Let’s now take a look at the project’s sensitivity to changes in the level of costs. To calculate
the relevant sensitivity measure we need to identify the present value of the costs incurred
in all three years. As in the case of revenues, the costs will need to be adjusted for the
impact of taxes. Accordingly, we need to calculate the present value of a stream of three
cost outflows of £400 each, which is derived as: £500 x (1 – 20%) = £400.

Using the annuity factor as we did in the case of revenues, that is 2.531, we arrive at a
present value of approximately (£400 x 2.531 =) £1,012. The relevant sensitivity measure
amounts to the NPV of the project yields a result of:

This may be interpreted in the following way:

The NPV of the project would fall below zero if the costs projected for each year were
underestimated by more than 20%.

22
3. Tax rate:

Another variable, to which the investment is sensitive, is the tax rate, which has the
potential to impact project cash flows in two ways:

 Through the level of corporate income tax payable on cash flows generated by the
project, and;

 Through the tax relief on tax allowable depreciation.

Accordingly, the two effects need to be incorporated into the calculation of sensitivity. To
do that, we will compute the present value of the stream of tax payments in the three years
of the project, in each of the three years, amounting to: £600 income tax – £50 tax relief =
£550 outflow.

As we did in the case of measuring the sensitivity to changes in revenues and costs, we will,
once again, calculate the present value of the tax flows using the 3-year annuity factor at
the 9% rate, which equals 2.531. Consequently, the present value of the tax cash flows
equates (550 x 2.531 =) £1,392, and the sensitivity of the project’s NPV to changes in the tax
rate is:

We may therefore conclude that:

If the tax rate grew by 14.4%, the NPV of the project would fall to zero.

23
Investment Project Duration
INVESTMENT APPRAISAL AND PROJECT DURATION:

As you can imagine, information about when an investment will, in fact, breakeven is vital to
the assessment of its riskiness. The longer it takes for the project to recover its costs, the
more risky it is in the eyes of investors. When companies plan their investments, one of the
most crucial aspects of appraisal is determining when the company will break even on the
project, that is, at which point in time the proceeds from the investment will exceed the
capital expenditure, which was required to launch the project.

Here, we will review, with help of numerical examples, the following:

1. Traditional payback period:

The traditional method of determining the breakeven point on an investment is the payback
period, which is simply the number of periods it takes for an investment to generate an
amount of income or cash equal to the cost of the investment. Please note that for
investment projects, where annual cash flows are equal, the payback period may be
calculated as simply as by dividing the amount of initial investment by the annual free cash
flow. The major drawback of the payback period is that it fails to take into account the time
value of money.

2. Discounted payback period:

The payback period may also be calculated on the basis of discounted cash flows, and is
then referred to as the discounted payback period. The main difference to the traditional
payback period is that the discounted measure shows the breakeven point in real terms, or
in terms of the value of money from the point in time when the investment is actually made,
whereas, traditional payback period presents the breakeven point in terms of nominal
future cash flows. The shorter the discounted payback period, the more attractive, and also
less risky, the project is to investors.

3. Macaulay duration:

Macaulay duration, also simply referred to as duration, is a more sophisticated measure of

the time that investors have to wait to receive cash inflows. Mathematically, duration is the
weighted average number of periods required until the cash flows generated from an
investment are received. When duration is calculated using a project’s cost of capital, it may
be interpreted as the average number of years needed to recover the present value of the
investment. Typically, duration is used in the measurement and management of interest
rate risk of investments in fixed coupon bonds, because it shows the sensitivity of a bond’s
value to changes in interest rates. The higher the duration, the more risky the bond is.
Duration may also be computed for investment projects with fixed cash flows, and used in

24
investment appraisal together with such measures as discounted payback period. When
calculating duration:

– We first need to compute the sum of the present values of all future cash flows
generated by the investment, computed at the project’s cost of capital.

– Next, we have to calculate the sum of the same present values, but weighted by
time.

– Duration will be given by:

Duration = Sum of time weighted PVs/ Sum of ordinary PVs

EXAMPLE:

Let’s now turn our attention to an example, in which we will get an opportunity to inspect
the sensitivity of an investment project’s NPV to the level of revenues, costs and tax rates.
Assume that an investment requires an initial capital outlay of £6,000 pounds. In each of the
subsequent 3 years, revenue from the investment is expected to equal £3,500. The annual
level of operating expenses expected to be incurred in association with the investment
amounts to £500. Let us further assume that the rate of income tax is 20% and that the
relevant cost of capital equals 9%. The annual tax relief due to the depreciation of assets is
£50. Let’s calculate the project’s NPV and then analyse how sensitive it is to changes in the
level of revenues, costs and tax rates. The applicable discount factors for 9% discount rate
are:

 0.917 for year 1;

 0.842 for year 2;

 0.772 for year 3.

The free cash flows generated by the investment opportunity are:

Year 0 (£) 1 (£) 2 (£) 3 (£)

Capital expenditure (6,000)
Revenue 3,500 3,500 3,500
Cost (500) (500) (500)
Operating CF 3,000 3,000 3,000
Tax @ 20% (600) (600) (600)
Depreciation tax saving 50 50 50
Free Cash Flow (6,000) 2,450 2,450 2,450

25
Traditional payback period:

As the cash flows generated in all years of the investment horizon are equal, the traditional
payback period is calculated as:

Initial investment 6,00

0
Payback period (Constant) Annual free cash = 2,45 = 2.45
= flow 0 years

So, without taking into account the time value of money, the initial investment should be
recovered within 2.45 years.

Discounted payback period:

In order to calculate the discounted payback period, we need to compute the discounted
cash flows of the project.

We do this by multiplying the free cash flow generated in each year by the appropriate
discount factor. So:

For year 1, the discounted cash flow amounts to: £2,450 x 0.917 = £2,247. For year 2, the
discounted cash flow amounts to: £2,450 x 0.842 = £2,063. For year 3, the discounted cash
flow amounts to: £2,450 x 0.772 = £1,891.

Let’s see how much time has to pass before the cumulative discounted cash flows equate to
the size of the initial investment. As you may notice, after two years the cumulative
discounted cash flows will be equal to the sum of £2,247 pounds and £2,063 pounds, which
is £4,310. This means that the discounted payback period must be longer than two years,
because (6,000 – 4,310 =) £1,690 still remain to be recovered. Knowing that in year 3 the
discounted cash flow amounts to £1,891, we may calculate the remaining portion of year
three, during which the project will generate the £1,690 pounds still outstanding. We
achieve this by dividing 1,690 by 1,891, which produces: 1,690 / 1,891 = 0.89.

Consequently, the discounted payback period equals (2 + 0.89 =) 2.89 years, which is
significantly higher than the traditional payback period computed previously.

The difference between the discounted payback period and the traditional payback period is
the larger, the higher the cost of capital of the investment.

Macaulay duration:

Let us now compute the duration of the sample investment project, based on which we
calculated the payback

periods. The project generated three cash flows:

– £2,450 in years 1;

– £2,450 in years 2;
26
– £2,450 in years 3.

The cost of capital was assumed to equal 9%, which corresponds to discount factors of:

 0.917 for year 1;

 0.842 for year 2;

 0.772 for year 3.

Applying these factors generates the following present values:

– £2,450 x 0.917 = £2,247 in respect of year 1;

– £2,450 x 0.842 = £2,063 in respect of year 2;

– £2,450 x 0.772 = £1,891 in respect of year 3.

We will start by summing these discounted cash flows, which produces a total equal to
(2,247 + 2,063 + 1,891 =) £6,201.

In the next step, we have to calculate the time-weighted sum of the same discounted cash
flows. To do that we multiply the discounted cash flow falling in year 1 by the number of
years, in which the cash flow will occur, that is by 1. Then, the discounted cash flow
computed in respect of year 2 needs to be multiplied by the digit 2, and finally the cash flow
falling in year 3 has to be multiplied by 3. This operation produces:

 £2,247 x 1 = £2,247 for year 1;

 £2,063 x 2 = £4,126, for year 2;

 £1,891 x 3 = £5,673 for year 3.

The sum of the products is (2,247 + 4,126 + 5,573 =) £12,046.

Now, duration is calculated by dividing £12,046 by the ordinary sum of discounted cash
flows, which came in at £6,201 pounds. As you can see, the duration of the project is:

27
Monte Carlo Simulations in Investment Appraisal
SIMULATION:

A simulation means that random numbers are picked in order to select sample values of
those variables, whose impact is to be analysed. With these sample values, we may next
calculate the hypothetical NPV of a project. When random sampling is conducted a
sufficiently large number of times, we receive a set of hypothetical project NPVs, whose
statistical characteristics, such as distribution, mean and standard deviation may be
analysed.

THE MONTE CARLO SIMULATIONS:

The Monte Carlo method was developed in the 1940s by a Polish-American physicist
Stanislaw Ulam. The early version of the Monte Carlo approach assumed that all simulated
variables are statistically independent. Later, more sophisticated variations of Monte Carlo
emerged, taking into account statistical relationships between the variables.

The statistical background of the Monte Carlo method is not within the scope of this
course.

EXAMPLE:

Let’ assume that a company is considering investing in a project. The two variables,
identified as having the biggest impact on the project’s future profitability are the levels of
revenue and costs. The variables are assumed to be independent, implying that there is no
relationship between them. The company expects that a certain level of costs will be
incurred with a certain probability. Similar assumptions are made with regard to specific
levels of revenue.

The simplest way of using Monte Carlo simulation involves assigning double digit numbers
to the revenues and costs expected to be achieved with certain degrees of probability. For
example:

28
The next step involves performing the actual simulations, by generating random numbers,
typically with the aid of a computer. It is essential that the format of these numbers allows
for their easy interpretation. In the above example, we have two variables, each assigned a
double digit number. So a possible format would be a 4 digit number, where the first 2 digits
correspond to revenues and the 2 last digits to the level of costs.

For example:

SUMMARY:

The Monte Carlo method is a sophisticated approach, which may only be implemented by
companies which possess human resources with the requisite level of expertise in the fields
of mathematics and statistics. The method is gaining in popularity due to the increase in the
availability of computer-assisted finance tools.

29
CAPITAL RATIONING:
In reality, capital is scarce and companies are seldom in a position to finance all profitable
investments. Capital rationing is an approach to the selection of an optimum mix of
investments, which the company is able to fund, taking into account its access to capital.

APPROACHES TO CAPITAL RATIONING:

1. Profitability index:

A profitability index (PI) indicates which projects are the most productive in terms of
generating profits from a single unit of invested capital, it is computed as:

PI = NPV ÷ Capital outlay

The major drawback of the profitability index method is that it only allows for the rationing
of capital in situations when a shortage is observed over a single period of time. So, the
method cannot be applied for the purposes of multi-period capital rationing

Example:

Consider a company has €40 million capital available for investment, with three investment
opportunities, X, Y and Z. Following are the capital outlay and NPVs of the investments:

Project X Project Y Project Z

Capital outlay (A) €27 million €10 million €19 million

NPV (B) €80 million €25 million €50 million

PT (B/A) 2.96 2.50 2.63

30
 a) If projects are independent and divisible:

Let us further assume that the considered projects are independent and divisible, meaning
that the company may invest in more than one project, and also in a portion of a project.
Thus, in order to maximise NPV, the company should decide to pursue project X, which has
the highest profitability index. The investment in X will consume €27 million of the available
funds, and so the company should spend the remaining €13 million on a partial undertaking
of project Z, which is the second most profitable investment among the options considered.
The portion of project Z that will be invested in amounts to 68%, which may be calculated as
the €13 million of available capital divided by the €19 million required to launch project Z in
its entirety. By investing in such a mix, the company will spend the whole capital available,
generating a total NPV of €114 million euro, which comprises 80 million from project X plus
68% of the 50 million NPV of project Z:

NPV = €80,000,000 + (€50,000,000 x 68%) = €114,000,000.

b) If projects are independent but not divisible:

Let’s now assume that the projects are not divisible, but remain independent. In such a case
the company will have to choose between simultaneously investing in projects X and Y or Y
and Z. Let’s analyse which option is more profitable.

When investing in X and Y, the company would have to spend a total of €37 million (that is
27 million on project X and a further 10 million on Y). The total NPV from investing in the
two projects amounts to €105 million (comprising 80 million from project X and 25 million
from project Y). Consequently, the profitability index of the entire investment comes in at
2.84 (or 105 million divided by 37 million).

If the company decided to simultaneously invest in projects Y and Z, then the capital
invested would equal the €10 million needed for project Y and a further €19 million required
in respect of Z, that is a total of €29 million. The overall NPV would equal €75 million euro
(consisting of the 25 million generated from project Y and the 50 million from project Z). So,
the profitability index of the investment in Y and Z would amount to (75 million / 29 million)
2.59.

As you can see, investing in projects X and Y is better in terms of both the profitability index,
and in terms of absolute NPV. Accordingly, the company should choose to invest €37 million
in projects X and Y. Given the absence of other investment opportunities, the company may
distribute the remaining 3 million euro of capital to investors in the form of dividends.

c) If projects are indivisible and mutually exclusive:

Let us now inspect the investment projects once again, this time assuming that they are
indivisible and

31
mutually exclusive. In such a case, the company can invest only in one chosen project. In the
analysed example, the project which maximises shareholder return is project X, which has
the highest absolute NPV.

2. Linear programming:

Linear programming (or linear optimisation) is a mathematical method, which allows for the
obtaining of an optimal solution, where more than one variable is unknown and the
relationships among the variables may be expressed linearly.

Stages of linear programming include:

 Defining variables (proportion of projects).

 Formulating objective function (overall NPV of project mix).

 Formulating constraints (requirements of all variables to be non-negative).

Example:

Let’s assume a company can raise a maximum capital of $20 million in year 1 and $8 million
in year 2. The company has three investment opportunities, with following specifications
and NPVs:

Project A ($’million)

Y1 Y2 Y3

Cash flow (10) (10) 30

DF (@10%) 0.909 0.826 0.751

PV (9.09) (8.26) 22.53

NPV 5.18

Project B ($’million)

Y1 Y2 Y3

Cash flow (20) - 35

DF (@10%) 0.909 0.826 0.751

PV (18.18) - 26.29

NPV 8.11

32
 Project C ($’million)

Y1 Y2 Y3

Cash flow (20) (8) 39

DF (@10%) 0.909 0.826 0.751

PV (18.18) (6.61) 29.29

NPV 4.50

In order to solve this multi-period capital rationing problem, we may apply the linear
programming approach. First, we need to define the unknowns:

 Variable a = the proportion of involvement in project A;

 Variable b = the proportion of involvement in project B;

 Variable c = the proportion of involvement in project C.

The linear optimisation function can be expressed as:

Maximise (a5.18) + (b8.11) + (c4.50)

The constraints can be formulated as:

 a, b, c  0

 a10 + b20 +c20  20 – for year 1

 a10 + c8  8 – for year 1

As we already mentioned, the mathematical details of solving linear programming problems

are not within the scope of this course. We may, however, review and explain the results.
The solution to the problem is such that variable “a” should equal 80%, variable “b” should
equal 60%, and variable “c” should be zero.

Consequently, in order to maximise the total NPV of its investments, the company should
invest in 80% of project A and in 60% of project B, while project C should be abandoned. We
may now review the financial results of applying the solution. Let’s first check how much
capital will, in fact, be spent.

Investing in 80% of project A implies that the company will need $8 million in year 1 and a
further $8 million in year 2, while investing in 60% of project B will require an outlay of $12

33
million in year 1 and nothing in year 2. So, together the suggested mix of investments
requires investing $20 million in year 1 and $8 million in year 2, which exactly reflects the
capital available in those two years. Looking at profitability, investing in the suggested mix
will allow the company to generate a total net present value equal to $9.01 million, which
may be calculated as 80% multiplied by $5.18 million, being the total NPV of project A, and
60% multiplied by $8.11 million, which is the total NPV of project B.

NOTE: The details of linear programming are not within the scope of this course.

34
Revision
International Investment- Dec 2013 Q1 - Chumra

QUESTION

Theoretically, in a perfectly effective market, the premium, which a bidder pays for shares of
the target should be equal to the increase in the bidder’s shareholder wealth following the
acquisition.

Since becoming independent just over 20 years ago, the country of Mehgam has adopted
protectionist measures which have made it difficult for multinational companies to trade
there. However, recently, after discussions with the World Trade Organisation (WTO), it
seems likely that Mehgam will reduce its protectionist measures significantly.

Encouraged by these discussions, Chmura Co, a company producing packaged foods, is

considering a project to set up a manufacturing base in Mehgam to sell its goods there and
in other regional countries nearby. An initial investigation costing $500,000 established that
Mehgam had appropriate manufacturing facilities, adequate transport links and a
reasonably skilled but cheap work force. The investigation concluded that, if the
protectionist measures were reduced, then the demand potential for Chmura Co’s products
looked promising. It is also felt that an early entry into Mehgam would give Chmura Co an
advantage over its competitors for a period of five years, after which the current project will
cease, due to the development of new advanced manufacturing processes.

Mehgam’s currency, the Peso (MP), is currently trading at MP72 per $1. Setting up the
manufacturing base in Mehgam will require an initial investment of MP2,500 million
immediately, to cover the cost of land and buildings (MP1,250 million) and machinery
(MP1,250 million). Tax allowable depreciation is available on the machinery at an annual
rate of 10% on cost on a straight-line basis. A balancing adjustment will be required at the
end of year five, when it is expected that the machinery will be sold for MP500 million (after
inflation). The market value of the land and buildings in five years’ time is estimated to be
80% of the current value. These amounts are inclusive of any tax impact.

Chmura Co will require MP200 million for working capital immediately. It is not expected
that any further injections of working capital will be required for the five years. When the
project ceases at the end of the fifth year, the working capital will be released back to
Chmura Co.

Production of the packaged foods will take place in batches of product mixes. These batches
will then be sold to supermarket chains, wholesalers and distributors in Mehgam and its
neighbouring countries, who will repackage

35
them to their individual requirements. All sales will
be in MP. The estimated average number of
batches produced and sold each year is given below:

Year 1 2 3 4 5

Batches produced and sold 10,000 15,000 30,000 26,000 15,000

The current selling price for each batch is estimated to be MP115,200. The costs related to
producing and selling each batch are currently estimated to be MP46,500. In addition to these
costs, a number of products will need a special packaging material which Chmura Co will send
to Mehgam. Currently the cost of the special packaging material is $200 per batch. Training and
development costs, related to the production of the batches, are estimated to be 80% of the
production and selling costs (excluding the cost of the special packaging) in the first year,
before falling to 20% of these costs (excluding the cost of the special packaging) in the second
year, and then nil for the remaining years. It is expected that the costs relating to the
production and sale of each batch will increase annually by 10% but the selling price and the
special packaging costs will only increase by 5% every year.

The current annual corporation tax rate in Mehgam is 25% and Chmura Co pays annual
corporation tax at a rate of 20% in the country where it is based. Both countries’ taxes are
payable in the year that the tax liability arises. A bi-lateral tax treaty exists between the two
countries which permits offset of overseas tax against any tax liabilities Chmura Co incurs on
overseas earnings.

The risk-adjusted cost of capital applicable to the project on $-based cash flows is 12%, which is
considerably higher than the return on short-dated $ treasury bills of 4%. The current rate of
inflation in Mehgam is 8%, and in the country where Chmura Co is based, it is 2%. It can be
assumed that these inflation rates will not change for the foreseeable future. All net cash flows
from the project will be remitted back to Chmura Co at the end of each year.

Chmura Co’s finance director is of the opinion that there are many uncertainties surrounding
the project and has assessed that the cash flows can vary by a standard deviation of as much as
35% because of these uncertainties.

Recently Bulud Co offered Chmura Co the option to sell the entire project to Bulud Co for $28
million at the start of year three. Chmura Co will make the decision of whether or not to sell the
project at the end of year two.

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Required:

(a) Discuss the role of the World Trade Organisation (WTO) and the possible benefits and
drawbacks to Mehgam of reducing protectionist measures. (9 marks)

(b) Prepare an evaluative report for the Board of Directors of Chmura Co which addresses
the following parts and recommends an appropriate course of action:

(i) An estimate of the value of the project before considering Bulud Co’s offer. Show all
relevant calculations; (14 marks)

(ii) An estimate of the value of the project taking into account Bulud Co’s offer. Show all
relevant calculations; (9 marks)

(iii) A discussion of the assumptions made in parts (i) and (ii) above and the additional
business risks which Chmura Co should consider before it makes the final decision whether or
not to undertake the project. (14 marks)

Professional marks will be awarded in part (b) for the format, structure and presentation of
the report. (4 marks)

(50 marks)

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