FINANCIAL

MANAGEMENT

6. SELECTION AND HIERARCHICAL EVALUATION OF

SIMPLE INVESTMENT PROJECTS: NPV AND IRR

In the business world, there are certain investment decisions that, given their strategic
nature, need to be analysed with the utmost care applying certain analysis
methodologies that allow studying these investments from a general approach.

The purchase of a patent, the internationalisation of a company, the opening of a new

production line or the acquisition of a property are all major, often irreversible decisions.
Normally, this kind of decision implies large amounts of funds that are not easily
available.

In this section we will deal with the analysis and hierarchical evaluation of simple
investment projects, introducing the perspective of the Net Present Value (NPV) and the
Internal Rate of Return (IRR) as valuation criteria.

Page 113

 FINANCIAL MANAGEMENT

6.1. OBJECTIVES

ü Study of variables of an investment project

ü Approach to the analysis

ü Selection of investment projects

ü Analysis and strategic evaluation

The development of a business activity requires, on the part of the management, the
analysis and selection of the investment projects necessary to address the regular
development and growth of the company. These decisions can positively influence a
company’s continuity and survival or, on the contrary, entail serious complications.

For this reason, investment decisions, due to their strategic nature, should be made with
the greatest possible guarantees of success and after a prior exhaustive analysis of all
variables that may determine the selection of one investment project over another.

Therefore, the investment analysis tools should be adjusted to different decision-making

levels, so that we can decide between different investment alternatives that are
presented to the company, and thus choose the one that best fits the context of the
business activity.

6.2. STUDY OF VARIABLES OF AN INVESTMENT PROJECT

All decision-making processes rely mainly on four elements:

1.Evaluator, it can be an analyst, an investor, a lender or a particular individual.

2. Internal variables, controllable by the decision maker. They can be acted upon, and
they may determine the final result (term, amount of the investment, etc.)

3. External variables, they are uncontrollable, and may also influence the final result.

Page 114

 FINANCIAL MANAGEMENT

4. Other options or alternative projects that have to be considered when choosing the
investment alternative (Investment in the Stock Market or Government Debt).

Before choosing any investment project, it is essential to previously determine some

basic variables: time horizon, initial investment to be made, residual values of the
investment, return on investment as well as the expected cash flows and the rate of
return.

§ Determination of the horizon of analysis:

Time horizon:

This estimation is made with the aim of analysing the useful life of the investment
project. Exceptionally, there are projects in which, due to the uniqueness of their
activity, the life of the investment may be determined with approximate certainty.

For example, a mining extraction project or an administrative concession for the

construction and operation of a highway are cases in which a defined time horizon may
be scheduled. However, in most cases, the exact life of a project cannot be determined
beforehand with certainty, so it is necessary to select an estimated time horizon, which
can be based, among others, on the following temporary factors:

a) Useful life, operating time interval.

b) Business life is based on the period of time during which the goods
produced by the project activity meet the market demand.

c) Technological life is the time that elapses until assets stop being
competitive and become obsolete due to new, more efficient
technologies that develop the same activity in less time, with a higher
quality and at a lower cost. An example would be computer applications.

d) Estimation of experts, for example, in the case of mineral deposits the

useful life will be determined by their size.

Page 115

 FINANCIAL MANAGEMENT

§ Determination of the investment

It is very important to establish beforehand the funding requirements that the

investment project will need throughout its life. The flow of funds that will absorb the
project will be determined by the investments that will be required at any time.

The invested funds can be broken down into two categories:

1. Investment in fixed assets. One tends to attach importance to investments

that need to be made before the start of the investment project so as to be able
to undertake it. Nevertheless, it is also important to consider investments that
will be necessary during the development of the investment project. For these
reasons, it is essential to set out a calendar of required investments. Thus, we
need to bear in mind that it is vital not only to consider the initial investment in
the project, but also the investments that will be necessary during the life of the
non-current asset to maintain it in optimum and profitable operating conditions.

2. Investment in working capital. It refers to the short-term investment

necessary for the normal development of the project activity. Its purpose is to
fill in cash gaps that occur during the life of the project.

There is an important difference between the investment in fixed assets and the
investment in working capital because while the investment in working capital
practically remains throughout the horizon of the analysis and is recovered at
the end of the project, the investment in fixed assets may lose or gain value over
time.

§ Residual values of the investment

It is a cash flow that consists of the residual or disposal value of the remaining assets at
the end of the analysis period. On many occasions, the asset has a residual value in the
market, since it can be sold as used or second-hand goods, or a scrap value, as in the
case of boats.

Page 116

 FINANCIAL MANAGEMENT

§ Determination of net cash flows

At this stage, the aim is to quantify the volume of resources generated by the project
throughout the horizon of study. The determination of the funds generated during the
life of an investment project can be done using the following scheme:

+ Revenues

- Expenses

- Depreciations

= Profit before tax (PBT)

- Corporate tax

= Net operating profit after tax (NOPAT)

+ Depreciations

= NET CASH FLOW

In the section of revenues from the activity, we group together all concepts producing
income from the regular activity of the project. Every subsequent cost will in turn
subtract funds from the income of the company.

Nevertheless, we will not subtract expenses from the latter net figure that do not imply
any cash outflow from the company: depreciations and provisions. This way, we will get
the profit before tax (PBT).

Then, the corporate tax is calculated which will involve a cash outflow of the project and
will allow quantifying the net operating profit after tax (NOPAT).

Page 117

 FINANCIAL MANAGEMENT

Finally, to determine the net cash flow of the period, depreciations will have to be added
again. The reason for it is that, although depreciations do not represent a real outflow
of money, they have a fiscal impact on the final result, since they are a deductible
concept. That is why they are first removed; by reducing their amount from the taxable
amount, the corporate tax could be calculated properly. Then it is necessary to add this
concept again to obtain the net cash flow of the period.

Example: Imagine that a company’s sole asset is a vehicle used to provide transportation
services. According to the previous study of the investment, with a 5-year time horizon,
it would obtain the following estimated cash flows:

YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5

Revenues

Transportation services 50,000 60,000 70,000 45,000 35,000

Residual Value Sale 5,000

Expenses

Deferred acquisition 30,000 5,000 5,000 5,000 5,000

Consumption 3,000 3,500 9,000 4,500 3,400

Maintenance, repair and operations 500 700 3,000 1,000 1,200

Vehicle Tax 200 200 200 200 200

Page 118

 FINANCIAL MANAGEMENT

Financial expenses 1,000 1,000 750 500 250

Depreciations 10,000 10,000 10,000 10,000 10,000

Profit Before Tax 5,300 39,600 42,050 23,800 19,950

Corporate Tax1 1,590 11,880 12,615 7,140 5,985

Net Profit After Tax 3,710 27,720 29,435 16,660 13,965

Depreciations 10,000 10,000 10,000 10,000 10,000

NET CASHFLOW 13,710 37,720 39,435 26,660 23,965

1
Tax rate used for calculation = 30%.

As can be seen in the example above, throughout the life of this investment project,
positive cash flows are produced every year.

§ Determination of valuation rate

The time horizon of the investment project and of the associated financing should
coincide because upon project completion, the logical conclusion will be that the
associated financing will end as well.

Page 119

 FINANCIAL MANAGEMENT

There are two conditions:

1. Condition of possibility or economy, according to which the sum of all cash

flows needs to be higher than the initial investment.

2. Condition of effectiveness or profitability, according to which the rate of

return on the investment has to be higher than the cost of capital of the financial
resources invested.

The optimal valuation rate to be used in the study of any project needs to comply with
the principle that the cost of the liability that finances the new project will be the
minimum profitability required by the project investment. In our example, the minimum
return required needs to be at least 5% of the cost of financing the purchase. That is, if
we assume that we have several sources of financing a project, the weighted average
cost of the liabilities included in the project will be the representative indicator of the
minimum profitability required by it.

6.3. APPROACH TO ANALYSIS

In order to carry out the correct evolution of an investment project, it is necessary to

adopt an approach that allows us to provide as much information as possible, to make
an accurate decision. In this sense, the analysis process could correspond to the
following diagram:

Page 120

 FINANCIAL MANAGEMENT

§ Previous analysis

This phase involves obtaining as much information as possible in order to perform a truly
reliable and precise study of the investment project.

The internal and external aspects that affect the project need to be thoroughly analysed.
It is about studying the environment where it will take place, as well as the possible
alternatives or courses of action.

We should pay attention to the following aspects:

- Market, so as to extend our knowledge about the potential customer, the level of
competition, etc.

- Product and its features: innovative, differentiated, non-differentiated.

- The necessary development process.

- Resources, financial as well as technical and human.

- Location: advantages and disadvantages of one location or another.

- Legal environment and its impact.

Before embarking on an investment project, all of the above-mentioned circumstances

should be carefully considered.

§ Identifying the fund movement

The purpose of an investment study is to determine, as accurately as possible, the

amount of the investment, payments and collections of the project analysed to decide
afterwards whether or not it should be carried out. Firstly, it will be necessary to identify
generated fund movements and, secondly, to study their evolution.

Page 121

 FINANCIAL MANAGEMENT

The estimation of cash flows involves quantifying future cash inflows and outflows.
Logically, the company should discard an investment project that generates a negative
cash flow, barring further considerations.

§ Analysis of profitability

Profitability is the ability to generate a surplus of funds or returns.

At this stage, it is analysed if the investment project meets the minimum required
profitability requirements.

The economic evolution of a project is based on the following variables:

- Investment amount

- Cash flows

- Investment horizon

- Project valuation rate

It is necessary to keep in mind that the measurement of the profitability of a project is

not always easy or quick to estimate since forecasting the behaviour of variables
sometimes causes difficulties.

Project profitability can be measured in many different ways. This way we can
distinguish between several methods of investment evaluation that involve comparing,
through a series of techniques, project cash flows with the expected profitability and
the investment made. These techniques or criteria of analysis can be classified into:

Page 122

 FINANCIAL MANAGEMENT

This method is based on
the relationship between
Net return criterion
cash inflows and

disbursements to be made
throughout the project.

This analysis complements
the previous one, since it
Accounting return
considers the net
criterion
accounting performance

between the number of

years the investment

project lasts.

Non-financial criteria. The

chronology of cash flows Period of time in which the

is not considered. initial disbursement of an

Payback criterion
investment is recovered.

Financial criteria. The Net present value (NPV) criterion

chronology of cash flows
as well as the time value of
money are considered.
Internal rate of return (IRR) criterion

Page 123

 FINANCIAL MANAGEMENT

§ Pay-back

It determines the number of periods necessary for the accumulation of cash flows to
recover the value of the initial investment.

"#ₒ
For constant flows: PB = (CF = cash flows).
"#

%"#
For variable flows: PB =
"#

Pay-back is a liquidity criterion according to which liquid investments are preferred

rather than mainly profitable ones and are used when an investment project implies
very high-risk associated levels.

§ Net present value (NPV) criterion

Net Present Value (NPV) is the difference between the present value of cash inflows and
the present value of cash outflows over a period of time.

&"#t
NPV = Σ ()* ͭ - initial investment

Key:

NCFt = Net cash flow at the specific moment.

K = Project evaluation rate.

t = Period of time considered.

In this way, investments with a positive NPV will be selected as profitable; that is,
investment projects whose discounted net cash flows (referenced to a current moment)
are greater than the initial investment and, as a result, the project realisation will be
profitable. If the company may choose among several investment projects with a
positive NPV, it should select the one with the highest NPV.

Page 124

 FINANCIAL MANAGEMENT

To illustrate, let us look at the following investment project table of a company:

Year Payments Collection Net Cash Flow Discounted

net Cash Flow

0 225 -225 -225

1 50 100 50 45.45

2 0 75 75 61.98

3 100 200 100 75.13

4 250 400 150 102.45

TOTAL 625 775 150 60.01

If we assume that the valuation rate of the project is 10% (minimum profitability
required for the project), we will get:

((--./-) 2/ (4--.(--) 6--.4/-)

NPV = -225 + + + + = 60.01 MUE
(.(- (.(-² (.(-³ (.(-⁴

The NPV of this example indicates the value obtained by the company: 60.01 MUE. This
value is higher than what the investors had demanded from the capital invested (10%).

Page 125

 FINANCIAL MANAGEMENT

a) Advantages of NPV:

- Taking account of time value of money, placing emphasis on earlier cash flows.

- Looking at all the cash flows involved in the life of the project.

- The use of discounting reduces the impact of long-term, less likely cash flows.

- Having a decision-making mechanism – rejecting projects with negative NPV

b) Disadvantages of NPV:

- It is complicated to select a valuation rate.

- Unrealistic assumptions for the reinvestment of intermediate flow generated by the

investment. The NPV criterion assumes that positive cash flows are reinvested as long
as the investment lasts, at an interest rate equal to the valuation rate chosen. Moreover,
it assumes that negative net cash flows are financed by capital whose cost is also equal
to the same valuation rate.

- The need for forecasts concerning future cash flows.

- Difficulty in establishing the future discount interest rate.

§ Internal Rate of Return (IRR)

Internal rate of return (IRR) is the interest rate at which the net present value of all the
cash flows (both positive and negative) from a project or investment equals zero.

&"#8
Initial investment = Σ(()9) ͭ

Key:

NCFt = Net cash flow at a specific t moment.

Page 126

 FINANCIAL MANAGEMENT

r = Internal rate of return (IRR) of the project

The IRR of a project always remains the same and will be determined exclusively by the
initial investment and the net cash flows.

In order for an investment to be feasible, its IRR should be higher than the minimum
required rate of return on the invested capital. For this reason, an investment project,
with a certain IRR, may be attractive to some investors but not to others, depending on
the profitability required from the project.

Below you can see a breakdown of the above-mentioned example:

Year Payments Collection Net Cash Flow

0 225 -225

1 50 100 50

2 0 75 75

3 100 200 100

4 250 400 150

TOTAL 625 775 150

The NPV of this project, as we saw in the previous section, and taking into consideration
the required 10% profitability, is:

Page 127

 FINANCIAL MANAGEMENT

((--./-) 2/ (4--.(--) 6--.4/-)

NPV = -225 + + + + = 60.01 MUE
(.(- (.(-² (.(-³ (.(-⁴

In this example, the NPV shows that the project generates the required 10% and, in
addition, 60.01 MUE. That is to say, it provides the investor with a return higher than
the 10% demanded initially. This circumstance indicates that the project may be
required to earn a profit higher than this 10% rate. But, how much else can be expected?
The maximum rate required would be the one that makes the NPV zero. To do this, we
will "confront" the capital invested initially with the current net cash flows. The discount
rate that makes NPV equal zero becomes the IRR of the project:

((--./-) 2/ (4--.(--) 6--.4/-)

225 = + + + +
(() 9) (( ) 9)² (() 9)³ (()9)⁴

The solution to this equation reveals the following IRR:

r = IRR = 19.80%

Given that the project IRR (its profitability) is higher than the minimum 10% required,
the project is viable. For levels with a required profitability lower than 19.80%, the
project will be accepted and the lesser the required rate of return, the more attractive
the project will be since it will provide a profit margin higher than the one required. For
required rates of return higher than 19.80% the project will be rejected.

a) Advantages of IRR:

- It considers the time value of cash flows.

- It provides a measure of the profitability of the project.

- It measures the relative profitability of investment projects.

Page 128

 FINANCIAL MANAGEMENT

b) Disadvantages of the IRR:

- Difficult calculation.

- It considers the hypothesis of reinvestment of intermediate funds generated by the

project at a rate equal to the IRR.

§ Risks analysis

Once the economic viability of the project has been verified, the next step is the analysis
of it. This analysis is based on the behaviour of the variables that form part of the study
of the investment project and on the estimation of the values of these variables. The
results obtained depend on compliance with these estimates.

Imagine a rise in exchange rates not foreseen in the initial study of an investment project
subject to the acquisition of a fixed asset abroad. This may cause a greater outflow of
funds for the payment of this asset and, as a result, may cause project results different
from the ones initially estimated.

In this situation, we may have several possible results within a specific range of
possibilities as some variables of the project may be changing as well. This variability of
results is what introduces the risk factor in the project.

In short, the risk derives from the uncertainty in the values that variables (internal and
external) affecting the analysed project may present.

When analysing the investment project, some risk analysis procedures should be
performed as they allow establishing, in a reasonable manner, the margins of variation
of the project results as well as the critical factors that may have a considerable impact
on the project outcome.

The analysis of risks method consists of two stages: sensitivity analysis and scenario
analysis.

Page 129

 FINANCIAL MANAGEMENT

To start with the analysis of risks, it should be reminded that although many variables
are involved in the final result of the project, variations in some of them greatly influence
the final result. In this sense, the first stage of analysis of risks is to determine the
influence of each variable on the outcome of the project. This is known as sensitivity
analysis. It involves a separate examination of changes in a variable and their impact on
the NPV of the project. The pessimistic and optimistic estimations of the relevant
variable are established. Eyes are set on the effect of changes made, but not on the
likelihood of the occurrence of these changes.

Subsequently, the interrelation of the variables and the influence on the result of the
project need to be analysed. It is a multivariate analysis on the correlation of the critical
variables involved in an investment project.

In our example of acquiring a non-current asset abroad through supplier financing,

logically two interrelated critical variables are the variable interest rate of the supplier
and the exchange rate.

Furthermore, scenario analysis is a method of predicting future values of investments

based on potential events. In other words, it is a method of estimating what will happen
to a project’s values if a specific event happens or does not happen, and may be used to
examine a theoretical worst-case scenario.

(For more information see appendix no. 02. - Sensitivity analysis)

§ Financial analysis

In terms of economic feasibility, obviously it is critical to consider financing aspects when

studying the movement of funds.

Once the feasibility of the project has been estimated, the next step is to choose the
appropriate financial structure and determine the flow of funds. In this sense, when
choosing the appropriate financial structure for an investment project, it will be
necessary to pay attention to both the cost of the financing and the cash deficit that it

Page 130

 FINANCIAL MANAGEMENT

may cause. That is, the financial structure that best matches the company’s cost and
liquidity situation should be picked.

The steps one should follow when determining the financial structure of the project:

a) Determination of the total volume of financial resources necessary to undertake the

investment that will be made.

b) Defining the dimension and estimating the actual costs of every financial source to be
used, both in the long and short term.

c) Determination of the most interesting financial source (own/third party,

internal/external), taking into account both the cost and its temporary distribution.

Naturally, from the point of view of cost, the most interesting financial source is the one
that implies the lowest cost. Likewise, it is important to remember how demanding the
different financial sources are so that they do not cause liquidity problems. For this
purpose, the so-called "financial feasibility" will be carried out, consisting of the
temporary and quantitative adjustments between the net investments and the
payments derived from the undertaken financial obligations.

6.4. SELECTION OF INVESTMENT PROJECTS

When available resources are not sufficient to cover all investment projects that may be
attractive, the company needs to select projects. The company has to choose the project
or projects that are able to generate a greater profitability for the company, provided
that a certain level of risk and a minimum of liquidity is guaranteed.

To do so, the company will prepare a ranking of projects, ordering them according to
the profitability indicators previously studied.

Page 131

 FINANCIAL MANAGEMENT

Example: let us look at the following projects:

PROJECT YEAR 0 YEAR 1 YEAR 2 YEAR 3

A -100 15 30 105

B -100 -- 30 125

C -100 35 35 35

What is the most attractive alternative if the minimum profitability required for all
projects is 8%? To answer this question, we calculate the NPV and the IRR and we opt
for the one with the highest value:

PROJECT PNV IRR

A 22.95 MUE 17.14%

B 24.94 MUE 16.98%

C -9.88 MUE 2.48%

In view of these results, project C is not viable because its NPV is negative and its IRR is
lower than the minimum profitability required. The other two projects are attractive for
the company, yet project B is preferable due to a higher NPV although the IRR of project
A is higher.

Now we will turn to a set of exercises concerning the NPV and the IRR, so that you can
understand and practice the calculations necessary for determining these values:

Page 132

 FINANCIAL MANAGEMENT

Exercise 5:
We want to determine whether the following investment project is feasible, considering
the present net value (NPV) and an initial outlay of €2,000. Net cash flow
generated is €200 for the first year, then €300 (2nd year), €500 (3rd year) and
€1,200 (4th and last year of activity). Profitability expected – without considering
inflation – is 8%. The annual cumulative rate is 9%.

In this case:
K = 0.08 + 0.09 + 0.08 x 0.09 = 1.772

That is to say, if the requested profitability in absence of inflation is 8%, a
cumulative inflation rate of 9% results in a requested profitability of 17.72%.

SOLUTION
With this information, the following may be deduced:
200 300 500 1200
NPV = -2,000 + 1.772 + + +
1.7722 1.7723 17724

Therefore, and since NPV is negative, investment is not recommendable

according to this criterion because the current value of cash flows is not enough to
recover the value of the initial outlay.

Exercise 6:
An investment requires an initial outlay of €1,000. Its duration is two years. Cash flows
generated -€800 at the end of the first year, and €600 at the end of the second one.
What is the IRR?

SOLUTION
800 600
0 = -1,000 + 𝑙+𝑟 + 2
(𝑙+𝑟)

If we solve the quadratic equation, the result obtained is:

r = 0.2718 times l

Page 133

 FINANCIAL MANAGEMENT

Exercise 7:
An investment requires an initial outlay of €1,500 and flows generated are listed in the
next chart:

Years (€) Collections (€) Payments
First 3,000 2,500
Second 4,500 3,500
Third 5,000 4,500
Fourth 3,000 2,000

Which rates make it feasible and which ones do not?

SOLUTION

First, we need to calculate the net cash flow by subtracting payments from collections
in the table:
First year: 3,000 – 2,500 = €500
Second year: 4,500 – 3,500 = €1,000
Third year: 5,000 – 4,500 = €500
Fourth year: 3,000 – 2,000 = €1,000

If NPV equals 0, the value of r is obtained:

500 1000 500 1000
0 = -1,000 + (𝑙+𝑟) + 2 + 3 + 4
(𝑙+𝑟) (𝑙+𝑟) (𝑙+𝑟)

Since it is not possible to clear r from this formula, and in absence of a computer or
financial calculator, we will have to use estimates and then proceed by trial and error
until checking that its value is 0.3197. For rates lower than 31.97% NPV is positive and
so, the investment is feasible. For rates higher than 31.97%, NPV is negative and it
follows that the investment is not feasible.

Page 134

 FINANCIAL MANAGEMENT

Exercise 8:
An investment requires an outlay of €8,000 and lasts 2 years. In the first one the net
cash flow is €2,000, whereas in the second year it is €4,500. You need to calculate the
NPV considering that there is an annual cumulative inflation rate of 6%, and the
requested return rate 8% without considering the inflation.
SOLUTION

K = 0.08 + 0.06 + 0.08 x 0.06 = 0.1448
Then:
2,000 4,500
NPV = -3,000 + 1.1448 + = €2,180.66
1.4482

*Examples extracted from: Aguer Hortal, Mario Pérez Gorostegui, Eduardo & Martínez
Sánchez, Joan (2007). Administración y dirección de empresas: teoría y ejercicios resueltos.
Madrid, Editorial Universitaria Ramón Areces.

6.5. STRATEGIC ANALYSIS AND EVALUATION

The objective of the strategic analysis is to study the factors that affect the investment
project and are not strictly quantitative in nature.

When selecting an investment project, the management team not only needs to focus
its study on the investment project itself and on the variables that directly affect it in a
quantitative way (yields, rates, flows, etc.) but, it should also include an analysis of all
factors of qualitative nature that may have an influence on the project and its results.
For example, the possible environmental impact or a change in the applicable legislation
should be taken into consideration.

The strategic factors that need to be considered (depending on the nature of the
investment project to be carried out) are the following:

Page 135

 FINANCIAL MANAGEMENT

- Compatibility of the objectives of the project with those of the investors.

- Managerial ability of the management team.

- Technical viability of the processes, products and services.

- Ability to market.

- Opportunities and threats of the market. SWOT ANALYSIS

- Strengths and weaknesses of the project.

- Legal aspects.

- Environmental factors.

- Evolution of the political, social, economic, etc., context.

In conclusion, when deciding on an investment project, it is very important to take into

account all controllable and non-controllable aspects that may impact, both positively
and negatively, the development, evolution and finalisation of the investment project.

Page 136