Projects often require substantial initial investments, and companies may have limited financial resources – whether this be internally or externally generated. As such, the projects available to be taken are therefore restricted by the amount of capital available, and companies must assess each project and decide which projects to take to achieve the maximum return. Likewise, large projects are often long-term in nature, and thus the future cash flows expected to be generated need to be adjusted for inflation.
Prices usually rise over time due to inflation, therefore, when analysing a project that will take place over a number of years, the element of inflation must be taken into consideration, as it will affect the cash flows. However, the rate of inflation is not always predictable, and thus unanticipated inflation adds to the risk of the project.
Types of Inflation
Specific inflation: this is the inflation on a specific product.
General inflation: this is the rate of inflation on a ‘basket’ of goods and is usually referred to as the ‘general price index’.
Rates of Return and Inflation
As mentioned in the first post ‘Payback Periods, ARR, NPV and IRR’ of this investment appraisal series, there are two types of cash flow:
- Money cash flows: expressed as the amount of money actually expected to be received/paid.
- Real cash flows: expressed in terms of today’s purchasing power.
Example. – Money and real inflation rates
Grenham Plc. have a possible investment opportunity that will cost £120,000 and will generate the following cash flows expressed in terms of today’s purchasing power.
Year 1 45,000
Year 2 55,000
Year 3 65,000
The company’s money cost of capital is 15% and inflation is currently 4%.
Calculate a) the project’s NPV in money terms, and b) calculate the NPV in terms of today’s purchasing power.
a) Money Cash Flows
If the cash flows are given as real cash flows, then they need to be inflated to make them money cash flows.
Year 1 45,000 x 1.04 = 46,800
Year 2 55,000 x 1.042 = 59,488
Year 3 65,000 x 1.043 = 73,116
NPV = (120,000) + (46,800 / 1.15) + (59,488 / 1.152) + (73,116 / 1.153) = £13,752
b) Real Cash Flows
If the cost of capital given is a money cost, then the real cost needs to be calculated.
1.15 / 1.04 = 1.1058 = (1.1058 – 1) x 100 = 10.58%
NPV = (120,000) + (45,000 / 1.1058) + (55,000 / 1.10582) + (65,000 / 1.10583) = £13,745
The different in real and money cash flows is due to rounding.
Capital rationing occurs when there are not enough funds to take all positive NPV projects. There are two main types of capital rationing:
- Hard rationing: funds are externally rationed e.g. banks are unwilling to lend anymore money to a company, stock market is not prepared to fund the company any further etc., meaning that the company simply cannot raise the funds it needs.
- Soft rationing: funds are internally rationed by the company, often for control purposes e.g. the company may have a funding limit, and it also helps to control the strategic direction of the company by restricting managers to act within a restricted scope.
One Period Rationing:
This is where capital is rationed for this time period i.e. 12 months, but will not be rationed for future time periods.
Divisible projects are those where it is possible to only take part of the project.
e.g. if the project was to run 50 TV adverts, 20% could be taken and 10 adverts run. This means the company would receive 20% of the cash flows (NPV) – however this is a major assumption, it may generate higher or lower cash flows.
Profitability index: compares the cash flows generated by the project with the initial capital investment, and shows the amount of return earned for every £1 of investment.
PI = (Net) Present Value / Initial Investment
Projects are chosen in order starting with the highest PI, as this would give the greatest return per £1 of investment. The projects are invested in until all the cash available is used. If a project is reached where there is not enough cash to fund the whole project, then the remaining cash will be used to fund a proportion of that project.
Divisible projects are those that must be taken in full or not at all e.g. buying a machine – you cannot buy a single part of it.
The PI is not suitable for indivisible projects. Instead, the NPV of all possible combinations of projects should be calculated using the money available, and the combination with the highest NPV should be chosen.
Example – Divisible and indivisible projects
Projects A and C are mutually exclusive. The amount of rationed capital available is £6m. Calculate which projects should be taken if a) all the projects are divisible, and b) if all the projects are indivisible.
a) Divisible (using PI rank)
a) Divisible (using NPV rank)
Although projects E and D have the same PI value, due to the inherent risks associated with longer projects, it is logical that the company would choose to invest in the project with the quickest return first i.e. project D – this would also help with any cash flow problems, or likewise may help to better meet any project payback requirements.
b) Indivisible Cost NPV
Combo 1: A and B £6m £11.800m
Combo 2: A and E £6m £13.224m
Combo 3: B, C and D £6m £ 8.893m
Combo 4: C, D and E £6m £10.317m
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