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Investment Appraisal

Nature of Investment Decisions

Once the decision is taken, it has far-reaching consequences, which extend over a considerably

long period, and influence the risk

Complexion of the firm.

These decisions involves huge amount of money.

Irreversible once it is taken.

These decisions are among the most difficult to make when the company is faced with various

potentially viable investment opportunities.

Measuring cost and benefits of an investment proposal (not all costs and benefits may be able

to express in tangible terms).

The benefits of capital expenditure are expected to occur for a number of years in the future,

which is highly uncertain.

Because the costs and benefits occur at different points of time, investment proposal, for a

proper analysis of the viability of all these have to be brought to a common time frame (Time

value of money)

A project

Investment (initial)

Other expenses (during the period)

Income/revenue/sales

Dispose at the end.

Methods to make a sound investment decision

Non – discounting methods

Cost comparison methods

Profit comparison

Accounting rate of return

Payback method

Discounting methods

Time value of money

NPV

IRR

Discounting payback method

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my-business-economics-and-financial.html

Overview of the Statement of Cash Flows

Explains the reasons for a change in cash

Classifies the reasons for the change as an operating, investing or financing activity

Reconciles net income with cash flow from operations

Classifications of Cash Flows

Operations - Cash flows related to selling goods and services; that is, the principle business of the firm.

Investing - cash flows related to the acquisition or sale of non-current assets.

Financing - long term and short-term cash flows related to liabilities and owners’ equity; dividends are a

financing cash outflow

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my-business-economics-and-financial.html

Investment Analysis

For the Finance Manager, an investment is always considered as an expense or a series of expenses,

from which future cash flows are expected.

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my-business-economics-and-financial.html

Capital

In our economic environment, capital is the basic resource. Capital has the power to earn and satisfy our

needs.

Lender’s viewpoint

Capital can be spent on goods expected to produce a profit or personal satisfaction.

Lt could be loaned – if loaned lender will generally expect some type of compensation. The

common compensation is interest.

Interest compensate,

For the administrative expenses of making the loan,

For the risk that the loan will not be paid

For the loss of earnings that would have been obtained if, the money had been invested for

other productive purposes. (opportunity)

Borrower’s viewpoint

A loan is both an obligation and an opportunity.

Failure to repay leads to a damaged reputation, loss of possessions, and other consequences.

Time value Equivalence

If 1000 were sealed and buried today, it would have a cash value of 1000 when it was dug up 2

years from now.

If you deposit 1000 @ 10% interest compounded annually, you will receive 1210 after 2 years.

1000 today == 1210 in 2 years

To have 1000 in 2 years you need to deposit 1000(1+0.1)2 = 826.45 today.

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my-business-economics-and-financial.html

Net Present Value

As time value of money changes with each day, what we will earn in future may not equally valuable.

Therefore, in this method we bring all the values to present value, and check whether it is profitable.

Here is a example of use of NPV.

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Internal Rate of Return (IRR)

Definition: The IRR is simply the discount rate that equates a project’s NPV to zero.

The IRR is defined exclusively in terms of an asset’s cost and its cash flows. It is independent of

market rates.

Directly use the calculator to solve the equation, remember to use a initial value, otherwise it will take a

longer time to solve.

Question