MBS Corporate Finance 2023 Slide Set 3

CORPORATE FINANCE
SLIDE SET 3: MAKING INVESTMENT DECISIONS
PROF. DR. ERIK THEISSEN I NOV-DEC 2023

Course Outline
1. The NPV Method - Basics

2. Estimating Cash Flows
3. Discounting and the
Opportunity Cost of
Capital
4. Shortcuts: Annuities and
Perpetuities
5. Alternatives to the NPV
Rule
6. Capital Rationing
7. Flexibility (if time permits)
8. ESG Objectives
9. Supplementary Material
Course Outline

Opportunity Cost of
Capital
Perpetuities
Rule
8. ESG Objectives
The NPV Method - Basics
Which investments are worth to be undertaken?

• Those that "create value"
• An asset can have different values for different firms
• Question: Is the asset (more generally: the investment
project) worth more than the capital required to undertake
it?
• We need to estimate the value of an investment project for
a firm and compare it to the price of the asset
• We use the net present value (NPV) as our valuation
concept (but also discuss alternatives)
The NPV considers all cash payments associated with a

project
• Payments are made at different times (and thus cannot be
simply added up)
• Payments may be uncertain (= risky)
more risky investment— higher discount rate to calculate the present value
How to make payments comparable?

• We discount all future payments
• For discounting we use the rate of return of an alternative
investment with the same level of risk as our project
• This rate is the opportunity cost of capital. It is the return
we forego because we invest in the project
(Expected)
AMOUNT of
TIMING of cash flows UNCERTAINTY
cash flows of cash flows
NPV
The NPV concept has many important applications:

• Valuation of (real) investment projects
• Valuation of securities (= financial investments, e.g. stocks
and bonds)
• Valuation of businesses (“discounted cash flow valuation”)
- Mergers and Acquisitions
- Setting a price in an IPO
Course Outline

Opportunity Cost of
Capital
Perpetuities
Rule
8. ESG Objectives
Estimating Cash Flows
Where do the cash flow estimates come from?

Capital expenditure Operating cash flow
• What is needed? (land, • Sales
buildings, machinery, - what to produce?
software, patents, ...) - quantities and prices
• Prices? Timing of payments? - when do customers pay?
• Replacements during the • Raw materials
lifetime? - quantities and prices?
• Salvage value at termination? - when do we pay?
- inventories
• Wages
• Other items (insurance,
maintenance, ...)
• Tax payments
→ results in changes in
→ results in changes in
current assets / working
fixed assets
capital
Important issues
• Use cash flows, not accounting earnings
• Use incremental cash flows
• Consider all relevant cash flows (and only relevant cash
flows)
• Take inflation into account
• Include tax payments
• Perform a sensitivity analysis to check how sensitive the
estimated NPV is with respect to your underlying
assumptions
Cash flows versus accounting earnings:

• Cash flows are just cash inflows into and cash outflows out
of the firm
• Accounting earnings try to measure the change in the value
of the equity (the net book asset value) of the firm
• The two can be very different (remember our discussion in
chapter 1!)
• We use cash flows in order to take the time value of money
into account
What are incremental cash flows?

• Cash flows should be derived from a “with versus without”
comparison, not from an isolated project analysis
• The incremental cash flow is the change in the firm’s cash
flow due to the project
• It takes into account interdependencies between the new
project and the existing firm if firms build the factory —> forgo the rental income
- substitution (“cannibalizing”) if firm does not build the factory—> firm sells the lands—>
cash inflow in form of rent or sell (which is an opportunity
cost)
- complementarities
• Incremental cash flows may include opportunity costs
(e.g.: “if we don’t realize the project we can rent or sell the
piece of land”)
Which cash flows are relevant?

• Include opportunity costs!
• Do not include sunk costs! (“bygones are bygone”)
Going on is a better option and sunk

costs are gone and as we stand
today. We can take into account the
previous costs.
• Remember to keep track of changes in working capital

- Increase in working capital: Cash outflow
- Decrease in working capital: Cash inflow
Mini Case Surcharge Inc.

Surcharge Inc. can produce a new product. It expects to sell 10,000
units a year over 5 years. The expected unit price is 100€. The per-unit
cost of production is 40€ (assumed to be cash outflows). We assume
that these payments occur at year-end.
The new product requires an upfront investment of 2,250,000€. The
salvage value of the equipment at the end of year 5 is 0. There are no
other cash inflows or outflows associated with the new product. The
opportunity cost of capital is 8%. We disregard taxes.
When determining the total per-unit costs, the firm has a policy of
allocating overhead (10% of the per-unit cost of production).
Is the investment worthwhile? (Please ignore taxes)
Version A:
• Cash Flow years 1 - 5: 10,000*(100 - 44) = 560,000
• NPV at 8%: -14,082.38 includes overhead costs
Version B:
• Cash Flow years 1 - 5: 10,000*(100 - 40) = 600,000
doesnt includes overhead costs
• NPV at 8%: +145,626.02
Punchline:
• Be careful with allocated overhead costs - only include
additional cash flows which are caused by the project
How to calculate tax payments?

• Important:
Taxable Income ≠ Cash Flow
taxes are irrelevant cash flows and they are calculated as part of pretax income.
• Most important differences:

- Capital expenditure is not tax deductible
- Depreciation is tax-deductible (even though it is not a
cash outflow!) → “depreciation tax shield”
- Timing: The contract date matters, not the payment date
NPV with taxes in five simple steps:

1. Estimate pre-tax cash flows
2. Estimate the taxable income for each period
3. Apply the tax rate to the taxable income to obtain the tax
payments
4. Subtract the tax payments from the pre-tax cash flows (or
add them to the pre-tax cash flows; see below) to obtain
the after-tax cash flow
5. Calculate the NPV of the after-tax cash flows
Taxable income (simplified): + Sales

- Cost of goods sold
- Other costs
- Depreciation
The tax payments (taxable income x tax rate) are a relevant

cash outflow
Note:
• We do not take the tax savings due to the debt tax shield
into account when estimating cash flows
• Reason: As will be discussed in part 4, we adjust the
denominator for the tax effects and use "unlevered" cash
flows in the nominator (see BMA, p. 501)
Which of the following is a tax-deductible expense and

will thus appear in the firm's income statement?
A Capital expenditure
B Repayment of (the principal) of a loan
C Depreciation this is tax deductible!
Mini Case: Best Manufacturing

The Best Manufacturing Company is considering a new investment. Financial
projections for the investment are tabulated below. Cash flows are in € thousands,
and the corporate tax rate is 34%. Assume all sales revenue is received in cash, all
operating costs and income taxes are paid in cash, and all cash flows occur at the
end of the year. The salvage value at the end of year 4 is 0.
Year 0 Year 1 Year 2 Year 3 Year 4
Initial Investment 10,000
Sales revenue 7,000 7,000 7,000 7,000
Operating costs 2,000 2,000 2,000 2,000
Depreciation 2,500 2,500 2,500 2,500
Net working capital
(end of year) 200 250 300 200 0
a) Compute the after-tax net income of the investment for each year.
b) Compute the incremental cash flows of the investment for each year.
c) Now assume that the firm uses an accelerated depreciation scheme.
Depreciation now is (4000; 2400; 1800; 1800). Please recalculate the cash
flow stream of the project. Which scheme do you prefer?
overall positive cash flows if the firm is profitable.
Something to think about:

If the taxable income is negative - should we include a
negative tax payment in our cash flow forecast?
Course Outline

Opportunity Cost of
Capital
Perpetuities
Rule
8. ESG Objectives
Discounting and the Opportunity Cost of Capital
*Note: Slide taken from FA
A Euro today is worth more than a Euro in the future

• The Euro today can be invested and earns a return
C0 CT=C0(1+r)T
C0 C1=C0(1+r)
0 1 T Time
C0=C1/(1+r) C1
C0=CT/(1+r)T CT
The present value of the amount C1 paid one year from now is
C1
PV =
(1 + r )
where r is the discount rate
The present value of the amount Ct paid t years from now is
Ct
PV =
(1 + r )
t
A PV is the amount today that is equivalent to the future cash

flow. We can add up PVs (they are all expressed in current
Euros) in order to obtain the PV of a stream of cash flows as
T
Ct
PV = ∑
t =1 (1 + r )
t
Assume the price of the stream (the initial investment) is C0

(C0 will typically be negative). Then the net present value
(NPV) of the investment is
T
Ct
NPV = PV + C0 = ∑ + C0
t =1 (1 + r )
t
deducting initial investment
or simply
T
Ct
NPV = ∑
(1 + r )
t
t =0
Note:
• Some of the Cts may be negative
• A "typical" investment project has a negative cash flow
initially (C0 < 0) and positive cash flows thereafter
Example 1 (BMA p. 51)

• Your firm can buy a piece of land and construct an office
building. The price is € 370,000 to be paid now
• You expect that you can sell the building at € 420,000 one
year from now. The opportunity cost of capital is 5%
420, 000
NPV = − 370, 000 = 30, 000
1, 05
• The rate of return of the project is
future cash flow − investment 50, 000
r = = 0.1351 ≈ 13.51%
investment 370, 000
which is larger than the opportunity cost of capital
How positive NPV projects create value:

• If you realize the project, your current wealth increases by
the NPV of the project
t0 (now) t1 (one year from now)

Investment -370 420
Alternative investment -370 388,5
(opportunity cost of capital) (=370 * 1.05)
Difference 31.5
Discounted difference 30
(=31.5 / 1.05)
• Positive NPV projects should be accepted. Choosing all

positive NPV projects maximizes shareholder value
• Shareholders can agree on the NPV rule (and safely dele-
gate investment decisions to managers )
The decision criterion of the NPV method

• There is one project which can be accepted or rejected
("yes-or-no decision"): Accept the project if the NPV is
positive
Alternatively and equivalently: Accept the project if its rate of
return is above the "opportunity cost of capital"
• There are several projects and only one of them can be
accepted: Accept the project with the highest NPV (provided
this NPV is positive)
Important: No simple rule based on the rate of return (see
section on IRR for details!)
long term rate of loan is higher than short term loan rate
Note: But in usual cases , one discount rate should be used!
• In some applications (e.g. the valuation of bonds) different

discount rates are used for cash flows with different maturity
dates (reflecting a non-flat term structure of interest rates)
• We can easily accommodate this case: Simply discount
each cash flow at the discount rate that corresponds to the
maturity date of the cash flow (see next slide)
• In NPV calculations for real investment projects it is com-
mon practice to use a single opportunity cost of capital
• The "shortcuts" (annuity and perpetuity) are based on the
assumption that all CFs are discounted at the same rate
• We will therefore maintain the assumption of a single rate
Discounting using different rates!!!
C0=C1/(1+r0,1) C1
C0=C2/(1+r0,2)2 C2
..
C0=CT/(1+r0,T)T CT
0 1 2 T Time
r0,1 r0,2 r0,T
discount rate (p.a.!)

How to deal with risk?

• Instead of sure cash flows we consider expected cash
We assume estimated scenarios
flows 1. base scenario

2. optimistic scenario
3. pessimistic scenario
• The correct discount rate is the rate of return on alternative

investments with the same level of risk
• Remember: Because of risk aversion, the rate of return will
increase in the level of risk (a safe Euro is worth more than a
risky Euro)
• Consequently, cash flows of more risky projects will be
discounted at higher rates
• Everything else equal, more risky projects will thus have
lower NPVs (see next slide)
Consider an investment that requires 100,000 today and

returns 110,000 on average one year from now:
Discount rate NPV

0 10,000
1% 8,911.9
2% 7,843.1
5% 4,761.9
10% 0
20% -8,333.33
How to deal with risk? (contd.)

• Problems (to be addressed in slide set 4):
- How to measure risk?
- What is the "risk-return tradeoff"?
More risky investment require more return on investment!
more risky projects—> higher opportunity cost and higher discount rate
109,000 is average of the 3

scenarios
but if the ratio is different
thats how you calculate future

value
Example (BMA08 p. 17/18) 0.25*80,000 + 0.5*110,000 +
0.25*137,000
• You have a project which requires a 100,000 € investment

now and yields the following payoffs in t=1, conditional on
the state of the economy (the states are equally likely)
Recession Normal Boom
80,000 110,000 137,000
• Assume there is a stock which has the same risk as your
project and which offers a 15% expected rate of return
• Then 15% is the appropriate discount rate (= the opportunity
cost of capital), resulting in a NPV of
Since NPV is negative, we shouldnot invest in this project
109,000
NPV = − 100,000 = −5,217.39
1,15
Example (contd.)
• The rate of return of the project is
109,000
=r −=
1 0.09 ≈ 9%
100,000
which is below the opportunity cost of capital
• Thus: It is better to invest the money in the stock which
yields 15% (rather than only 9%) and has the same level of
risk
when the project isnt profitable, the firm should pay dividends to the shareholders and they should go invest in the equity market
Assume the firm can obtain bank loans at 8%. Should you
now accept the project, based on a calculation such as the
following?
109,000
NPV = − 100,000 = +925,93
1,08
they should not do the project even with
the loan. Because the opportunity cost
with stock selection is still 15% more than
8%.
Return to the Best Manufacturing mini case and assume

the opportunity cost of capital is 12%
What is the NPV of the project?

we should use the rate which has different discount rate for different projects on the basis of risk associated with projects.
Consider a large firm with divisions in different industries.

Which discount rate (opportunity cost of capital) should be
used to estimate NPVs of new investment projects?
• The same rate for all divisions? use same rate only if same risk is prevalent amongst the projects
but calculating opportunity cost of capital
• One rate for each division? for different projects is difficult.
• A rate specific to each project?

Some firms deliberately use a discount rate that is higher

than the firm’s opportunity cost of capital. These firms
apparently forego profitable investment projects.
Can you think of reasons why this may make sense?

Firms have a organisational capacity to handle projects.
thus firms increase the discount rate to ensure the organisational capacity isnot maxed
out .
All projects aren’t available to the firm at the same time.
thus this could be a reason.
More on this topic: Jagannathan et al. (2016)

Research spotlight (Gormsen and Huber 2022, Graham 2022)

• Which discount rates do firms actually use, and how do they
relate to the (perceived) cost of capital?
Graham (2022, p. 1990)

Research spotlight (contd.)

• Data on discount rates and perceived cost of capital is
obtained from transcripts of conference calls
• Data on financial cost of capital is estimated by the authors
using the CAPM (for details of the method: chapter 4)

An (econometric)
note: The re-
gression includes
firm fixed effects.
Therefore, esti-
mates are driven
by within-firm
variation over time
increase in discount
rate can create a hurdle
and thereby investment
universe of the firm
decreases!

• The authors find that firms with more market power have
higher discount rate wedges
• Firms with market power thus appear to use higher discount
rates and invest less
Course Outline

Opportunity Cost of
Capital
Perpetuities
Rule
8. ESG Objectives
Shortcuts: Annuities and Perpetuities
Perpetuities:
• A cash flow stream that pays a fixed amount C at the end
of each year forever(!) is called a perpetuity
• The present value of a perpetuity is simply
C
PV =
r
• Note: C is the cash flow one year from now, but the
formula gives us the PV as of today
Annuities:
• Annuity: A cash flow stream that pays a fixed amount at the
end of each year for a specified number of years
(Payments at beginning of year: annuity due; see slide 55)
• The present value of an annuity is obtained by multiplying
the amount of the payment by the appropriate annuity factor.
It depends on t (the number of years over which payments
are made) and the opportunity cost of capital r
C
C 1 1 
PV = − r C −
= =C ⋅ AFr,t
r (1 + r ) t
 r r (1 + r ) 
t
Application:
• 8 years from now you need € 100,000 to repay a loan. How
much money do you need to put in a savings plan at the end
of each year in order to have € 100,000 at the end of year 8?
Assume the appropriate discount rate is 4%
• Step 1: The € 100,00 are the terminal value (TV) of the
annuity. Obtain the present value (PV) of the annuity:
TV
TV = PV ⋅ (1 + r ) ; PV = 100,000
t
= 73,069.02
(1 + r )
t 8
1.04 Present Value of 100,000 amount
Application (contd.):
• Step 2: With the PV of the annuity now given, we search the
amount of the annuity:
 1 1 
73,069.02 =
C ⋅ AF0.04;8 =
C − =C ⋅ 6.732745
 0.04 0.04 (1.04 ) 
8
• Solving for C gives us C = 10,852.78

Terminal value (period 8) Present value (period 0)

Period t Payment
Payment x1.04(8-t) Payment /1.04t
0 -- -- --
1 10,852.78 14,281.52 10435.37
2 10,852.78 13,732.23 10034.01
3 10,852.78 13,204.07 9648.08
4 10,852.78 12,696.22 9277.00
5 10,852.78 12,207.90 8920.19
6 10,852.78 11,738.37 8577.11
7 10,852.78 11,286.89 8247.22
8 10,852.78 10,852.78 7930.02
Sum 99,999.97 73069.00
Growing perpetuities: important part!
• A cash flow stream which pays a geometrically growing

amount (i.e. an amount that grows at a constant rate g) at
the end of each year forever is called a growing
perpetuity
• Note: The first payment is made at the end of the year
• The present value of a growing perpetuity is
always r > g
C r is the rate of growth of economy and g is the growth rate of

PV = firm
r −g for some firms we can say g must be greater r but that cannot
sustain for longer periods of time
where g is the growth rate and C is the first cash flow; it is

due one year from now(!)
Growing perpetuities - Applications:

• Important application: Valuation of stocks which are
expected to pay a growing dividend (dividend-growth
model or Gordon model)
• Often in firm valuations, the terminal value is derived by
assuming a growing perpetuity
A growth rate is estimated (and assumed to be
constant); the firm value at time H is estimated
Cash flows are estimated as the present value of a growing perpetuity
individually and discoun- (On the choice of the growth rate, see
ted Tengulov et al. 2019)
H
Be careful when applying the standard and growing perpe-

tuity formulas:
Assume that cash flows to ABC Corp. in 2024 and 2025 are 100.
Thereafter they increase by 2% each year (i.e. 102 in 2026, 104.04 in
2027 etc.). The opportunity cost of capital is 5%. We wish to estimate the
value today (year-end 2023) of ABC. Which of the following approaches
are correct?
100 100 102 ( 0.05 − 0.02 )
A + 2
+
1.05 1.05 1.053 this is correct!
100 100 102 ( 0.05 − 0.02 )

B + 2
+
1.05 1.05 1.052
100 100 ( 0.05 − 0.02 )
C +
1.05 1.052
100 100 ( 0.05 − 0.02 )
D +
1.05 1.05
Important question!!!!
Analyst Gordon Gecko estimates the free cash flows of XYC

corporation to be
2024 2025 2026 2027
5,000 5,500 5,900 6,200
After 2027 he expects the cash flows to grow at 3% a year

forever. The opportunity cost of capital is 8%. What is the
value estimate for XYZ at year-end 2023?
5000 5500 5900 6200
+ + + =
112, 463.8
1.08 1.082 1.083 ( 0.08 − 0.03) ⋅1.083
5000 5500 5900 6200 6200 ⋅1.03
or + + + + =
112, 463.8
1.08 1.08 1.08 1.08 ( 0.08 − 0.03) ⋅1.08
2 3 4 4
Constant payments made at Payments C(1+g)t-1, growing at constant rate

g, t=0 being the current period, made at
Payments the end of each the beginning of the end of each period the beginning of
are made: period each period („due“) each period („due“)
forever
(perpetuity) C
(1 + r ) C C
C r
r−g
(1 + r )
r C r−g
= C+
r
for t years
(annuity) 1 1   1 (1 + g ) 
t
C − t 
 r r (1 + r )  (1 + r ) C ⋅ AFr,t C  r − g − ( r − g )(1 + r )t  (1 + r ) C ⋅ GAFr,t,g
= C ⋅ AFr,t = C ⋅ GAFr,t,g
Course Outline

Opportunity Cost of
Capital
Perpetuities
Rule
8. ESG Objectives
Alternatives to the NPV Rule
Do firms actually use NPV? Here: US evidence. For international

evidence see Brounen et al. (2004)
Source: Graham (2022), p. 12
ROIC=Return on
invested capital,
ROIC = NOPAT / IC
Two widespread alternatives to the NPV rule:

• Internal rate of return
• Payback Period
Payback Period: Characterization

• Consider the cash flow stream of a “standard” investment
project (initial cash outflows, subsequent inflows)
• Determine the first period for which it holds that
Cumulative cash inflows ≥ initial investment
when you consider the payback period only , A is preferred over B which doesnt seem a very good idea.
• Examples time value of money is ignored in payback period which is evident in C & D PROJECT. both projects are
considered similar by payback period but C is better
Project C0 C1 C2 C3 Payback
Period
A -2,000 1,000 1,001 0 2
B -2,000 1,000 999 10,000 3
C -2,000 1,000 500 1,000 3
D -2,000 500 1,000 1,000 3
Evaluation Payback period advantages and disadvantages
• Easy to understand and use

• Requires definition of a cutoff period (“accept projects when
the payback period is below the cutoff”)
• Ignores cash flows after the cutoff date (see A and B)
• Ignores the time value of money (compare C and D!)
(may be cured, see supplementary material section)
• Ignores risk Ignore the riskiness of the project
• Cannot easily deal with non-standard cash flow patterns

(e.g. clean-up costs) clean up costs - where we have large cash outflow at the end of the projects. Eg coal industry where in
the end you have to apply clean up costs which isnt included in payback period.
• Tends to favor short-lived projects

many firms using payback period as an investment
• Not recommended decision raise a alarm bell as it isn’t very advantageous.
The IRR Rule: Intuition

• Express the attractiveness of an investment project by a
return figure
• Compare that figure to the opportunity cost of capital (the
“hurdle rate”)
• Accept a project if its rate of return exceeds the oppor-
tunity cost of capital
WHEN OPPORTUNITY COST IS EQUAL TO IRR , NPV becomes zero.
An introductory example:
• Consider a project which requires capital expenditure
100,000 today and returns (on average) 110,000 in a year
• The (expected) rate of return on this project is
110,000 − 100,000
rproject =
100,000
• Assume we use the project’s rate of return (instead of the
opportunity cost of capital) to calculate the project’s NPV:
NPV ( rPr oject ) =

110,000
−100,000 + =
0
110,000 − 100,000
1+
100,000
rate of return only one cash inflow and one cash outflow.
rate of return at which NPV becomes zero is defined as IRR.
Generalization:
• The NPV of a one-period project, obtained using the pro-
ject’s rate of return as the discount rate, is zero (by
definition). But what is the rate of return on a project with
more than two cash flows?
• We turn the whole thing around and define:
The Internal Rate of Return (IRR) of an investment project
is the rate of return which, if used as the discount rate,
results in a zero NPV
• The IRR is often used as a measure of the attractiveness of
a project: A project should be adopted if its IRR exceeds the
opportunity cost of capital
• Generally:
T
Ct !
∑ =0
(1 + IRR )
t
t =0
• Usually a numerical solution is required

Decision Rule: Important
• Decision on a single project (“yes/no”): Accept the project if

the IRR is larger than the opportunity cost of capital
Note: when this is the case for a “standard” investment
project, the project has positive NPV. The NPV rule and the
IRR rule thus yield identical results
• Choice between mutually exclusive projects: Choose the
project with the highest IRR??? NPV value should be used!
No!!!: The project with the highest IRR does not necessarily
have the highest NPV. The NPV rule and the IRR rule may
yield different results
Decision Rule:
• Decision on a single project (“yes/no”): Accept the project if
the IRR is larger than the opportunity cost of capital
Note: when this is the case for a “standard” investment
project, the project has positive NPV. The NPV rule and the
IRR rule thus yield identical results
• Choice between mutually exclusive projects: Choose the

project with the highest IRR???
No!!!: The project with the highest IRR does not necessarily
have the highest NPV. The NPV rule and the IRR rule may
yield different results
when opportunity cost > internal rate of return , NPV becomes negative.
thus we reject that project
when their are cash flows which are a combintaion of negative and positive cash flow, the project might have multiple IRR
Illustration: Yes / no-decision (project -100, 40, 40, 40)

25
20
15
IRR
10
5 NPV>0 NPV
NPV
0
Discount
0 0,02 0,04 0,06 0,08 0,1 0,12 0,14 0,16
Rate
-5
-10
NPV<0
-15
Problems of the IRR method:

• Investing or borrowing?
- When we invest we want a high IRR
- When we borrow we want a low IRR
- What to do about projects with non-standard cash flow
patterns (e.g. clean-up cost)
• The scaling problem: Which of the following two mutually
exclusive and non-scalable projects would you choose?
we choose the project with higher NPV (not choosing IRR)
(IRR implicitly assumes scalability)A is a smaller project and not earn us much euros.
IRR assumes scalability(projects can be done multiple times)
Project t0 t1 NPV (at 10%) IRR

A -10 13 1.82 30%
B -100 120 9.09 20%
Problems of the IRR method (contd.):

• Choice between mutually exclusive projects may be wrong
Below the intersection point , A is better than B but above the intersection point , B is better than A
Evaluation of the IRR method:

• Some of the problems can be addressed by modifications of
the IRR rule
• The IRR method is more complicated than the NPV rule, it
never yields better results but sometimes worse results
• The IRR may be used as a sensitivity analysis: By how
much can the discount rate increase before the NPV turns
negative?
• Bottom line: Use the NPV rule and be careful when
someone proposes to use IRR
there are a range of applications where IRR is a feasible option.
IRR is used as a sensitivity analysis. Opportunity cost is an estimated value and IRR helps us to know how it should be within IRR for NPV to be positive.
Course Outline

Opportunity Cost of
Capital
Perpetuities
Rule
8. ESG Objectives
Capital Rationing
Why may there be a shortage of capital?

• Firms in financial distress may face difficulties in raising
funds, or can obtain funds only at high cost (e.g. because
banks charge high interest rates - however, these may just
reflect the risk of the firm)
• Large firms often put limits (“budgets”) on the investment
spending of their divisions (“self-imposed” constraints)
• A “credit crunch” may occur: Even healthy firms have
difficulties in raising capital (e.g. because banks are in
trouble)
Capital Rationing
A simple example (BMA, p. 143):

• A firm has three projects but can only spend 10 million €
• There are no other constraints We want maximised NPV.
PV only has the future cash flows and doesn’t count the initial investment
Project C0 C1 C2 PV / NPV at 10%

A -10 30 5 31 / 21
B -5 5 20 21 / 16
C -5 5 15 17 / 12
• To maximize total NPV we sort projects by their profitability
index PV A PI = 3.1
B PI = 4.25
Profitability Index = B> C>A
C PI = 3.40
Investment
Benefits per Euro investment Since we have only 10 million , we
invest in Project B and C.
and accept them in this order until the budget is exhausted

Capital Rationing
Two definitions of the profitability index:

• HRWJJ, p. 165
PV
PIHRWJJ =
Investment
• BMA, p. 143: another definition of PI, the ultimate project list will be same no matter which formula we use.
NPV
PIBMA = = PV − Investment
; NPV
Investment
• The two versions are equivalent in that they produce the
same ranking (but they have different cut-off values!):
NPV PV − Investment
PIBMA = = = PIHRWJJ − 1
Investment Investment
• In our examples we use the HRWJJ version
Capital Rationing
Problems with the profitability index:

• There may be problems because projects are indivisible
A -5 15 2.5 15.5 / 10.5
B -6 6 24 25.2 / 19.2
C -5 5 15 17 / 12
• B has the highest profitability index (4.2 as compared to 3.1

and 3.4), but A and C together yield a higher NPV
Note: If B is adopted, there is no investment project for the
remaining 4 million €. The NPV method implicitly assumes
that they are invested at the opportunity cost of capital and
yield zero NPV (reinvestment assumption)
Capital Rationing
when there is a constant constraint on the capital investment, we cant make decisions on the profitability index alone and have to look at bigger picture of NPV.
Problems with the profitability index (contd.):

• Whenever there is a second constraint, ranking by the
profitability index is infeasible A PI = 3.1
B PI = 4.25
C PI = 3.40

A -10 30 5 31 / 21
B -5 5 20 21 / 16
C -5 5 15 17 / 12
D -40 60 53 / 13
• Assume cash in period 1 is also constrained at 10 million €

• B and C have the highest profitability index, but A and D
maximize NPV with B&C at day 1 we have cash outflow of 10 but with project A we have a cash outflow of 30 which can be invested in D.
With investments in A& D , NPV is 34 which is a better option.
Capital Rationing
Concluding notes: Disadvantages of Probability Index
• The profitability index can be a useful tool, but it should be

applied with care (remember the indivisibility problem)
• It should only be used when (a) the firm is really facing
capital rationing and (b) that constraint is only relevant in
one period (more complex methods are available if the firm
is facing constraints in several periods)
• In well functioning financial markets, rationing is rare
Course Outline

Opportunity Cost of
Capital
Perpetuities
Rule
8. ESG Objectives
Flexibility
Reconsidering the NPV rule:

• The NPV rule discounts expected cash flows by a (typically
constant) discount factor (the opportunity cost of capital)
• The NPV rule implicitly assumes precommitment to a given
path of action
• Different possible paths of action are (implicitly) treated as
mutually exclusive alternatives
• These assumptions may be inappropriate for multi-period
projects with flexibility
• The NPV rule may understate the value of a project
Flexibility
Example:
• Initial investment: 100
• Cash flows accrue perpetually
• Cost of capital: 10%, riskless rate 5%
12.5
• Two equally likely states of nature
good
• NPV:
bad
8
Flexibility
Assume we can defer the investment:

12.5
good
invest
bad
8 12.5
good
wait
invest
bad
8
don't
invest 0
Flexibility
NPV calculation:
• Invest now: NPV = 2.5
• Invest later: NPV = 2.5 / 1.1 = 2.27
• Don't invest: NPV = 0
However, delaying the project

• enables us to make the investment decision contingent on
the state of nature (the benefit)
• loses the period 1 cash flows (the cost)
Flexibility
A decision tree analysis yields the NPV:

12.5 0.10 − 100
0.5 ⋅ 0 + 0.5 =11.36
1.10
2.5
invest
25
invest
wait
0.5 don't
invest 0
-20
0.5 invest
don't
invest 0
Flexibility
The decision tree analysis

• assumes optimal decisions at each node
• uses a constant discount factor throughout the tree
The decision tree analysis values the option to delay at

Flexibility
Note:
• Flexibility is important (option to wait, option to expand,
option to abandon etc.)
• The assumption in our decision tree analysis of a constant
opportunity cost of capital is problematic (as uncertainty is
resolved, the opportunity cost of capital will change)
• Better approaches: Real options analysis
A warning:
• Be careful - real options are difficult to identify and value
• Check assumptions critically
Course Outline

Opportunity Cost of
Capital
Perpetuities
Rule
8. ESG Objectives
ESG Objectives
Traditional evaluation methods only consider financial object-

tives. What if shareholders and / or managers also have non-
financial (e.g. ESG = environmental, social, governance)
objectives?
• Is this a realistic scenario? Are shareholders willing to
forego financial benefits for other objectives?
• Section objective: Think about if / how to integrate ESG
considerations into capital budgeting procedures (where
we focus on the "E" part)
• What are the limitations of the approach?
• Note: This section draws on Hart and Zingales (2022)
ESG Objectives
Environmental damage caused by

• Production process (e.g. raising chicken using antibiotics)
- within the firm
- at suppliers
• Use of products (e.g. car buyers drive their SUVs)
→ scope 1 / 2 /3 emissions
ESG Objectives
Source: https://www.anthesisgroup.com/scope-1-2-3-emissions/, accessed June 24, 2022

ESG Objectives
How can we integrate ESG considerations into capital

budgeting decisions?
• Exclusion (define minimum standards for projects)
• Explicitly model the trade-off between financial objectives
and ESG objectives (requires quantification of ESG
issues)
ESG Objectives
Apparently there
are examples of
shareholders tra-
ding off non-finan-
cial for financial
objectives
ESG Objectives
Example important
• Assume that shareholders put weight λ on the welfare of

others and (1- λ) on their own. Assume further that welfare
can be measured in monetary units
• Assume the additional cost for Costco of not using anti--
biotics is 120 and the monetary benefit (e.g. savings in
healthcare costs) of not using antibiotics is 180.
ESG Objectives
Example (contd.)
• Assume Costco has three shareholders with equal stakes
• Stopping the use of antibiotics costs shareholder A 40 (1/3 of
the total additional cost), it costs other shareholders 80 (2/3)
and yields benefit 180.
• Shareholder A is in favor of stopping antibiotics use if
−40 + λA ( −80 + 180 ) ≥ 0 ⇒ λA ≥ 0.4
• Thus, if two shareholders have a λ above 0.4, the

shareholders meeting would vote in favor of stopping
antibiotics use
ESG Objectives
Conclusions and limitations

• Hart and Zingales (2022) refer to their concept as
shareholder welfare (as opposed to value) maximization
• If managers know their shareholders preferences they can
integrate them into their investment decisions
• However, if shareholders are heterogeneous, we would
need to aggregate their preferences
• Quantifying all costs and benefits to others may be hard
(and some things are quantifiable at all, e.g. saved lifes)
• "ESG" firms may also become takeover targets (there
should be a profit opportunity to selfish (i.e. λ=0) investors).
Will shareholders resist a high takeover premium?
Sometimes ESG policies are not sustainable and their is a risk of firm takeover.
Course Outline

Opportunity Cost of
Capital
Perpetuities
Rule
8. ESG Objectives
Supplementary Material
How to deal with inflation?

• Wages and prices tend to rise. Thus, nominal cash flows are
likely to also increase over time. Estimates of future nominal
cash flows have to take that into account.
• Two ways to deal with this
1. Estimate nominal cash flows and discount them using
nominal discount rates
2. Estimate real cash flows (cash flows in unchanged
prices) and discount them using real discount rates
• Do not mix the two procedures
(1 + rnominal )
• Real and nominal rates: (1 + rreal ) =
(1 + π )
Payback Period: Modification I

• Measures the payback period in fractions of the year
• Assumes that cash flows accrue continuously over the year
• Does not cure the main disadvantages
Project C0 C1 C2 C3 Payback NPV (at

Period 10%)
A -2,000 500 500 5,000 3 (2.20) +2,624
B -2,000 500 1,800 0 2 (1.83) -58
C -2,000 1,800 500 0 2 (1.40) +50
Modified criterion which assumes that cash

flows accrue continuously over the year
Modification II: Discounted payback rule:

• All cash flows are discounted
• Then the payback criterion is applied to the discounted
cash flows
• Solves (only) the time-value-of-money + risk problems
More problems of the IRR method:

• Non-additivity: You don’t easily get from the IRRs of a
firm’s projects to the IRR of the firm (Remember: NPVs are
additive!)
• Multiple IRR are possible
- There can be cash flow patterns that result in multiple
IRRs
• It may happen that no IRR exists
Reading List
Required Reading:
• Hillier, D., St. Ross, R. Westerfield, J. Jaffee and B. Jordan (2020):
Corporate Finance, Fourth European edition, chapters 4, 6, 7, 8.1, 8.3
and 8.4.
Supplementary:
• Brealey, R., St. Myers and F. Allen (2011): Principles of Corporate
Finance, 10th edition, McGraw-Hill. (abbreviated BMA in the slides)
• Brealey, R., St. Myers and F. Allen (2008): Principles of Corporate
Finance, 9th edition, McGraw-Hill. (abbreviated BMA08 in the slides)
• Brounen, D., A. de Jong and Kees Koedijk (2004): Corporate Finance
in Europe: Confronting Theory with Practice. Financial Management 33,
71-101.
Reading List
Supplementary:
• Fan, J., S. Titman and G. Twyte (2010): An International Comparison of
Capital Structure and Debt Maturity Choices. NBER Working Paper
16445, October.
• Gormsen, N.J. and K. Huber (2022): Corporate Discount Rates.
Working Paper, available at
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4160186
• Graham, J. (2022): Corporate Finance and the Real World. Presidential
Address, Journal of Finance 77, 1975-2049, also available at
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3994848.
• Hart, O. and L. Zingakes (2022): The New Corporate Governance.
NBER Working Paper 29975.
Reading List
Supplementary:
• Jagannathan, R., D. Matsa, I. Meier and V. Tarhan (2016): Why Do
Firms Use High Discount rates? Journal of Financial Economics 120,
445-463.
• Tengulov, A., J. Zechner and J. Zwiebel (2019): Valuation and Long-
Term Growth Expectations. Working Paper, November.
THANK YOU
VERY MUCH!
PROF. DR. ERIK THEISSEN I NOV-DEC 2023

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CORPORATE FINANCE

SLIDE SET 3: MAKING INVESTMENT DECISIONS

PROF. DR. ERIK THEISSEN I NOV-DEC 2023

1. The NPV Method - Basics

1. The NPV Method - Basics

Which investments are worth to be undertaken?

The NPV considers all cash payments associated with a

How to make payments comparable?

The NPV concept has many important applications:

1. The NPV Method - Basics

Where do the cash flow estimates come from?

Cash flows versus accounting earnings:

What are incremental cash flows?

Which cash flows are relevant?

Going on is a better option and sunk

• Remember to keep track of changes in working capital

Mini Case Surcharge Inc.

How to calculate tax payments?

• Most important differences:

NPV with taxes in five simple steps:

Taxable income (simplified): + Sales

The tax payments (taxable income x tax rate) are a relevant

Which of the following is a tax-deductible expense and

Mini Case: Best Manufacturing

overall positive cash flows if the firm is profitable.

Something to think about:

1. The NPV Method - Basics

A Euro today is worth more than a Euro in the future

A PV is the amount today that is equivalent to the future cash

Assume the price of the stream (the initial investment) is C0

Example 1 (BMA p. 51)

How positive NPV projects create value:

t0 (now) t1 (one year from now)

• Positive NPV projects should be accepted. Choosing all

The decision criterion of the NPV method

Note: But in usual cases , one discount rate should be used!

• In some applications (e.g. the valuation of bonds) different

discount rate (p.a.!)

How to deal with risk?

flows 1. base scenario

• The correct discount rate is the rate of return on alternative

Consider an investment that requires 100,000 today and

Discount rate NPV

How to deal with risk? (contd.)

Discounting and the Opportunity Cost of Capital

but if the ratio is different

thats how you calculate future

• You have a project which requires a 100,000 € investment

Return to the Best Manufacturing mini case and assume

What is the NPV of the project?

Consider a large firm with divisions in different industries.

• A rate specific to each project?

Some firms deliberately use a discount rate that is higher

Can you think of reasons why this may make sense?

thus this could be a reason.

More on this topic: Jagannathan et al. (2016)

Research spotlight (Gormsen and Huber 2022, Graham 2022)

Graham (2022, p. 1990)

Research spotlight (contd.)

Research spotlight (contd.)