Chapter - 11

Complex Investment
Decisions
Chapter Objectives
Show the application of the NPV rule in the
choice between mutually exclusive projects,
replacement decisions, projects with different
lives etc.
 Understand the impact of inflation on mutually
exclusive projects with unequal lives.
 Make choice between investments under
capital rationing.
 Illustrate the use of linear programming under
capital rationing situation.

By Akash Saxena
Complex Investment Problems
 How shall choice be made between
investments with different lives?
 Should a firm make investment now, or
should it wait and invest later?
 When should an existing asset be replaced?
 How shall choice be made between
investments under capital rationing?

By Akash Saxena
Projects with Different Lives
 The choice between projects with different
lives should be made by evaluating them for
equal periods of time.

Cash Flows (Rs 000)

0 1 2 3 4 NPV, 10%
Y1 60 40 40 0 0 129.42
Y2 0 0 60 40 40 106.96
Y = Y1 + Y2 60 40 100 40 40 236.38
X 120 30 30 30 30 215.10

By Akash Saxena
Annual Equivalent Value (AEV)
Method
 The method for handling the choice of the
mutually exclusive projects with different lives,
as discussed in last slide, can become quite
cumbersome if the projects’ lives are very long.
 We can calculate the annual equivalent value
(AEV) of cash flows of each project. We shall
select the project that has lower annual
equivalent cost.
NPV
AEV 
Annuity factor

By Akash Saxena
AEV for Perpetuities
 When we assume that projects can be
replicated at constant scale indefinitely, we
imply that an annuity is paid at the end of every
n years starting from the first period.
 (1  k ) n 
NPV  (NPVn )   
 (1  k ) n
 1 
 where NPV is the present value of the
investment indefinitely, NPVn is the present
value of the investment for the original life, n
and k is the opportunity cost of capital.

By Akash Saxena
Inflation and Annual Equivalent
Value
Machines X Y X Y X Y
Real Cash Flows (Rs 000) Nominal Cash Flows (Rs 000)
Year Inflation 5% Inflation 15%
0 120.00 60.00 120.00 60.00 120.00 60.00
1 30.00 40.00 31.20 41.60 40.50 54.00
2 30.00 40.00 32.45 43.26 54.68 72.90
3 30.00 33.75 73.81
4 30.00 35.10 99.65
Discount rate .06 .06 .144 .144 .265 .265
NPV 215.10 129.42 215.10 129.42 215.10 129.42
PVAF 1.7355 3.1699 1.6382 2.8900 1.4154 2.2999
AEC 67.86 74.57 74.43 79.00 93.52 91.44

By Akash Saxena
Investment Timing and Duration
 The rule is Project Undertaken
at Period NPV

straightforward: 0 –100 + 150  0.909 =

36.35

undertake the
1 –120  0.909 + 180  =
0.826 39.60
2 –140  0.826 + 205  =

project at that point 0.751 38.32

of time, which
maximizes the NPV.

By Akash Saxena
Tree Harvesting Problem
 The maximisation of the investment’s NPV would
depend on when we harvest trees. The net future value
of trees increases when harvesting is postponed; but
the opportunity cost of capital is incurred by not realising
the value by harvesting the trees. The NPV will be
maximised when the trees are harvested at the point
where the percentage increase in value equals the
opportunity cost of capital.
 Suppose the net future value obtained over the years
from harvesting the trees is At and if the opportunity cost
of capital is k, then the net present value (NPV) of the
net realisable value of trees is given by:
NPV = At e–kt – C
By Akash Saxena
Tree Harvesting Problem
 To determine the optimum harvesting time, which
maximizes the NPV, we set the derivative of the
NPV with respect to t in Equation equal to zero.
 Land may have value since the trees can be
replanted. Therefore, the correct formulation of
the problem will be to assume that once the trees
are harvested, the land will be replanted. Thus, if
we consider a constant replication of the tree-
harvesting investment indefinitely, then the NPV
will:
( At  C)
NPV  C  kt
e 1
By Akash Saxena
Replacement of an Existing Asset
 Compare the annual
equivalent value (AEV) of
the old and new equipment
as given below. Equipment C0 C1 C2 C3 C4 C5 NPV at
 It is indicated that a chain of 12%
new machines is equivalent New –12 6 6 6 6 6 9.63
to an annuity of Rs 9,630
 3.605 = Rs 2,671 a year Old – 4 3 2 – – 7.39
for the life of the chain. The AEV, New – 2.67 2.67 2.67 2.67 2.67 9.63
existing machine is still AEV, Old – 3.08 3.08 3.08 – – 7.39
capable of providing an
annuity of: Rs 7,390  2.402
= Rs 3,076. So long as the
existing machine generates
a cash inflow of more than
Rs 2,671 there does not
seem to be an economic
justification for replacing it.

By Akash Saxena
Investment Decisions Under Capital
Rationing
 Capital rationing refers to a situation where
the firm is constrained for external, or self-
imposed, reasons to obtain necessary funds
to invest in all investment projects with
positive NPV. Under capital rationing, the
management has not simply to determine the
profitable investment opportunities, but it has
also to decide to obtain that combination of
the profitable projects which yields highest
NPV within the available funds.

By Akash Saxena
Why Capital Rationing
 There are two types of capital rationing:
  External capital rationing.
  Internal capital rationing.

By Akash Saxena
Profitability Index
 The NPV rule should be modified while
choosing among projects under capital
constraint. The objective should be to maximise
NPV per rupee of capital rather than to
maximise NPV. Projects should be ranked by
their profitability index, and top-ranked projects
should be undertaken until funds are
exhausted.
 The Profitability Index does not always work.
It fails in two situations:
 Multi-period capital constraints.
 Project indivisibility.
By Akash Saxena
Programming Approach to Capital
Rationing
 Linear Programming (LP)
 Integer Programming (IP)
 Dual variable

By Akash Saxena