presented to the students in C.B.I.P.

on

Monday, April 08, 2013

By: R.C.Mukherjee

Sr.Faculty Member, PMI

Nature of Investment Decisions

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.The firms investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision. Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firms expenditures and benefits, and therefore, they should also be evaluated as investment decisions.

Features of Investment Decision

Thus the 3 characteristics of an investment decision are:-

The exchange of current funds for future benefits.

The funds are invested in long term assets.

The future benefits will occur to the firm over a

series of years.

Criterion for viability of a project :- It should maximize the shareholders wealth

Shareholders wealth will be maximized when :-

The projects expected rate of return > opportunity cost

of capital.

Importance of Investment Decisions

1. Growth :A firms decision to invest in long -term assets

has a decisive influence on its future growth

prospects.

2. Risks: A long-term commitment of funds may change

the risk complexion of the firm.

3.Funding: Procurement of funds :internally and

externally in advance.

4.Irreversibility:heavy losses if the project is closed down.

5.Complexity: Future cash-flows and cost of capital are

difficult to estimate and are subject to

political,economic,social and technological

forces.

Investment Evaluation Criteria

Three steps are involved in the evaluation of an investment:

Estimation of cash flows

Estimation of the required rate of return

Application of a decision rule for making the choice - project appraisal or capital budgeting techniques

Assumed

known

Investment Evaluation Criteria

The hallmarks of a sound technique are:

It should consider all cash flows to determine the true profitability of the project.It should provide for an objective and unambiguous way of separating good projects from bad projects.It should help ranking of projects according to their true profitability.It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.

Investment Evaluation Criteria

It should help to choose among mutually exclusive projects that project which maximises the shareholders wealth.It should be a criterion which is applicable to any conceivable investment project independent of others.

MOST

IMPORTANT

Project Appraisal Techniques

1.Non-discounted Cash Flow CriteriaPayback Period (PB)Accounting Rate of Return (ARR)2.Discounted Cash Flow (DCF) CriteriaNet Present Value (NPV)Internal Rate of Return (IRR)Profitability Index (PI)

Payback Period Method

Payback is the number of years required to recover the original cash outlay invested in a project. If the project generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow. That is:

Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. The payback period for the project is:

Payback Period = Rs.50,000 = 4 Years

Rs.12,500

Payback Period Method

Unequal cash flows In case of unequal cash inflows, the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay. Suppose that a project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the projects payback?

3 years + 12 (1,000/3,000) months

3 years + 4 months

Acceptance Rule

The project would be accepted if its payback period is less than the maximum or standard payback period set by management. As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period.

Evaluation of Payback

Certain virtues:Simplicity Cost effective Short-term effects Risk shield LiquiditySerious limitations: Cash flows after payback ignored Time Value of money ignoredCash flow patterns Administrative difficulties Inconsistent with shareholder value

Accounting Rate of Return Method

The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.A variation of the ARR method is to divide average earnings after taxes by the original cost of the project instead of the average cost.

Acceptance Rule

This method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate.This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.

Evaluation of ARR Method

The ARR method may claim some meritsSimplicity Accounting data Accounting profitability Serious shortcomingsCash flows ignored Time value ignored Arbitrary cut-off

Compounding & Discounting

Compounding : FV= PV (1+ r)n

Compounding Factor : (1+ r)n

Discounting: PV= FV [1/ (1+ r)n ]

Discounting Factor : [1/ (1+ r)n ]

Compounding & Discounting is based on :

Expected Rate Of Return -rTime Period - n

NET PRESENT VALUE METHOD

The Net Present Value (NPV) method is one of the discounted cash flow (DCF) techniques explicitly recognising the time value of money. The following steps are involved in the calculation of NPV:

Cash flows of the investment project should be forecasted based on realistic assumptions.Appropriate discount rate should be identified to discount the forecasted cash flows. This rate is the firms opportunity cost of capital which is equal to the required rate of return expected by investors on investment of equal risk.

NET PRESENT VALUE METHOD contd.

Present value of cash flows should be calculated using opportunity cost of capital as the discount rate.NPV should be found out by subtracting present value of cash outflows from the present values of cash inflows.The project should be accepted if NPV is positive (I.e., NPV > 0)

The formula for NPV is:

NPV = C1 + C2 + C3 + ..+ Cn - C0

(1 + k) (1 + k)2 (1 + k)3 (1 + k)n

Where C1, C2, C3 .. Cn represent cash inflows in the year

1,2, 3,n

NET PRESENT VALUE METHOD contd.

k = the opportunity cost of capital

C0 = initial cost of the investment and

N = expected life of the project.

Acceptance Rule:

Accept the project if NPV > 0

Reject the project if NPV < 0

May accept the project if NPV = 0

The NPV method can be used to select between mutually exclusive projects: the one with the highest NPV should be selected.

Implies increase in net wealth of the shareholders leading to higher share price

Implies decrease in net wealth

of shareholders

Implies net wealth of share

holders remains the same

Example

A company is considering an investment proposal requiring investment of Rs.1,00,000. Life of the project is 2 years and cash inflows are as under.

Years 1 2

Cash inflows 60,000 70,000

Expected rate of return from this project is 10%.

Evaluate financial viability of this project.

Solution

Present value of cash inflows: 1,12,360

Less: Present value of cash outflows: 1,00,000

NPV: 12360

yearsCash inflowsDiscounting factor at 10%Present value160,000.90954,540270,000.82657,820

Evaluation of the NPV Method

NPV is most acceptable investment rule for the following reasons:Time value Measure of true profitability Value-additivity Shareholder value Limitations:Involves cash flow estimation Discount rate difficult to determineMutually exclusive projects Ranking of projects

INTERNAL RATE OF RETURN METHOD

The Internal Rate of Return (IRR) method is another discounted cash flow (DCF) technique which takes into account the magnitude and timing of cash flows.

IRR is called so because it depends solely on the outlay and inflows associated with the investment and not on any rate determined outside the investment. It can be determined by the solving the following equation for r :

C0 = C1 + C2 + C3 + ..+ Cn

(1 + r) (1 + r)2 (1 + r)3 (1 + r)n

Where C1, C2, C3 .. Cn represent cash inflows in the year 1,2, 3,n

INTERNAL RATE OF RETURN METHOD- contd.

The value of r can be found by trial and error method.

It can be noticed that the IRR equation is the same as the one used for the NPV method with the difference that in the NPV method the required rate of return , k , is assumed to be known and the NPV is found, while in the IRR method the value of r has to be determined at which the NPV is zero.

INTERNAL RATE OF RETURN METHOD- contd.

Acceptance rule:

Accept if r > k

Reject if r < k

May accept if r = k

Calculation of IRR

Level Cash Flows Let us assume that an investment would cost Rs 20,000 and provide annual cash inflow of Rs 5,430 for 6 years.The IRR of the investment can be found out as follows:

Evaluation of IRR Method

IRR method has following merits:Time value Profitability measure Acceptance rule Shareholder value IRR method may suffer from:Multiple rates Mutually exclusive projects Value additivity

Profitability Index

Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.

Profitability Index

The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. Assume a 10 per cent rate of discount. The PV of cash inflows at 10 per cent discount rate is:

Acceptance Rule

The following are the PI acceptance rules:Accept the project when PI is greater than one. PI > 1Reject the project when PI is less than one. PI < 1May accept the project when PI is equal to one. PI = 1The project with positive NPV will have PI greater than one. PI less than one means that the projects NPV is negative.

0

Initial Investment

Payback = =

Annual Cash Inflow

C

C

Rs 50,000

PB = = 4 years

Rs 12,000

Average income

ARR =

Average investment

6,

6,

6,

NPVRs 20,000 + Rs 5,430(PVAF) = 0

Rs 20,000Rs 5,430(PVAF)

Rs 20,000

PVAF3.683

Rs 5,430

r

r

r

=-

=

==

A B C D E F G H

1 NPV Profile

2

Cash Flow

Discount

rate NPV

3 -20000 0% 12,580

4 5430 5% 7,561

5 5430 10% 3,649

6 5430 15% 550

7 5430 16% 0

8 5430 20% (1,942)

9 5430 25% (3,974)

Figure 8.1 NPV Profile

IR

R

.

1235

.

1

1,00,000

Rs

1,12,350

Rs

PI

12,350

Rs

=

100,000

Rs

112,350

Rs

NPV

0.68

20,000

Rs

+

0.751

50,000

Rs

+

0.826

30,000

Rs

+

0.909

40,000

Rs

=

)

20,000(PVF

Rs

+

)

50,000(PVF

Rs

+

)

30,000(PVF

Rs

+

)

40,000(PVF

Rs

PV

0.10

4,

0.10

3,

0.10

2,

0.10

1,

=

=

-

=

=