Investment Decision

In this chapter… Capital budgeting process… Basic principles of capital expenditure proposal… Various appraisal methods… Average rate of return… Pay back period… DCF Methods… NPV, IRR and Profitability Index… Merits and demerits of Appraisal methods… Conflicts in decision making… Capital Rationing… Investment Appraisal methods in Practice…

Capital Budgeting… The firm’s decision to invest its current

funds most efficiently in the ling term assets in anticipation of an expected flow of benefits over a series of years.

Importance of capital budgeting decision…

Growth. More Risky. Huge Investments. Irreversibility. Effects on other projects. Difficult decision.

Process of Capital Budgeting… Idea generation. Evaluation or Analysis. Selection. Financing the selected project. Execution or implementation. Review of the project.

Techniques of Investment Evaluation… Traditional Techniques.

Pay back period method. Accounting Rate of Return or Average rate of

Return.- ARR Modern Techniques or Discounted Cash

Flow Techniques. Net Present Value – NPV Internal Rate of Return – IRR Profitability Index - PI

Pay back period method… Pay back period: that period required to recover the

original cash outflow invested in a project. First Method: when the annual cash flows stream of

each year is equal or uniform, the following formula is used to know the pay back period:

PBP = Original Investment /constant annual cash flow after taxes.

Second Method: when the annual cash flows after taxes are unequal or not uniform over the projects life period.

PBP = Year Before Full Recovery + (Unrecovered Amount of Investment + Cash Flow During the Year)

Decision Rule for PBP… Accept : Cal PBP < Standard PBP Reject : Cal PBP > Standard PBP

Advantages of PBP… Simple and easy. Less costly. Modern method.

Limitations… It ignores cash flow after PBP. Does not consider all cash inflows yielded

by the investment. Does not consider TVM No rational basis for setting a minimum

PBP.

Accounting Rate of Return Method… It uses accounting information as revealed by financial

statements, to measure the profitability of the investment proposals.

Average annual earnings after depreciation and taxes are used to calculate ARR.

It is measured in terms of %. It is calculated in two ways: Whenever it is clearly mentioned as Accounting Rate of

Return. Whenever it is clearly mentioned as Average Rate of

Return.

Accounting Rate of Return… ARR = Average Annual EAT or PAT * 100

Original Investment (OI)

OI = Original Investment + Additional NWC +

Installation Charges + Transportation

Charge.

Average Rate of Return… ARR = Average Annual EAT * 100

Average Investments (AI)

AI = (Original Investment – Scrap Value)1/2 +

Additional NWC + Scrap Value

Decision Rule… Accept : Cal ARR > Predetermined ARR or

Cut off Rate. Reject : Cal ARR < Predetermined ARR or

Cut off Rate.

Advantages… Simple and easy. Information can easily drawn from

accounting records. It considers all profits of the projects life

period. Comparatively less costly.

Limitations… Ignores the TVM concept. Ignores retained earnings. Ignores size of the investment required for

each project.

Net Present Value… It is the process of calculating present

values of cash inflows using cost of capital as an appropriate rate of discount and subtract present value of cash out flows from the present value of cash inflow and find the NPV which may be positive or negative.

NPV = Present Value of Benefits – Present Value of Costs.

Decision Rule… Accept : NPV > 0 Reject : NPV < 0

Advantages… It considers the TVM. It considers all cash inflows occurring over

the entire life period of the project. Useful for selection of mutually exclusive

projects.

Limitations… Difficult to understand when compared with

PBP and ARR. Calculation of required rate or discounting

factor or cost of capital is difficult. Not useful when comparison of two projects

with different life periods.

Internal Rate of Return Method… When the discount rate at which present

value of cash inflows equals to present outflows, is IRR.

IRR Computed by Trial and error approach

IRR…

Where; LDF = Lower discount factor ΔDF = Difference between low discounting factor and High

discounting factor PVLDF = PV of cash inflows at low discounting factor PVHDF = PV of cash inflows at high discounting factor COF = Cash outflow Decision Role:

PVLDF - COFIRR = LDF % + ΔDF ---------------------- PVLDF - PVHDF

Decision Rule… Accept = Ko < IRR Reject = Ko > IRR

Advantages… Consider time value of money Consider CFs through project life Gives more psychological satisfaction Helps to maximum shareholders wealth

Limitations…• Assumption of profits are reinvested at IRR not

logical• Produces multiple rate of returns• Not suitable for evaluation mutually exclusive

projects• May not give fruitful results when project life or cash

outflows are unequal

Profitability Index [PI] Profitability Index means the index that is

desired by dividing PV of cash inflows by PV of cash out flows.

PI = PV of CIFs / PV of COFs Decision Rule:

Accept: PI > 1 Reject: PI < 1

Advantages… It gives due consideration to time value of money, It considers all cash flows to determine PI, It will help to rank projects according to their PI, It recognized that the fact that bigger cash flows are

better to smaller ones and early cash flows are preferable to later ones,

It can also be used to choose mutually exclusive projects by calculating the incremental benefit cost ratio.

It is consistent with the objectives maximization of shareholders’ wealth.